Locked lesson.

Upgrade

About this lesson

Return ratios are normally used for comparing companies or comparing the past performance of a company with its present performance.

Exercise files

Download this lesson’s related exercise files.

Return on … Ratios.docx
195.4 KB Return on … Ratios - Solution.docx
60.4 KB

Quick reference

Return on … Ratios

There are several ratios that are calculated by dividing the Net Income by another financial measure.  These ratios are often used to compare the efficiency of one company with another.

When to Use Return on … Ratios

Return ratios are normally used for comparing companies or comparing the past performance of a company with its present performance.  They provide a quick evaluation of the company efficiency.

Instructions

  • Return ratios are calculated by dividing the Net Income by another financial attribute.
  • The Return on Sales (ROS) is a popular ratio.  It shows how well the business is able to turn the activity of its current operations into profit. 
    • It divides Net Income for a period by the total sales for that same period. 
    • ROS can be increased by raising Net Income faster than an increase in sales.  This is normally achieved by cutting costs somewhere in the operations without the cost cutting impacting current sales. 
    • It is easy to raise ROS by stopping all investment activity.  This gives short term benefit but hurts the business in the long term.
  • The Return on Assets (ROA) is a business efficiency ratio.  It shows how well a company is able to use its asset base to create net income.  It is often used with companies that have a high level of capital or fixed assets.
    • The ROA is calculated by dividing the Net Income for a time period by the average total assets during that time period.  The average total assets are the average value for assets from the Balance Sheet at the beginning and the end of the time period.
    • ROA can be increased by increasing the Net Income through increased sales or lower cost or by lowering the asset base through the sale or disposal of assets.
    • ROA must be used carefully and the business operation must be well understood.  For instance, a company that uses contract manufacturing will often have a much higher ROA than one with its own factories since the company with contract manufacturing has fewer fixed assets.  However, the risk profile between companies is not the same, even though they are in the same industry.
  •   The Return on Equity (ROE) is a business efficiency ratio.  It shows how well the company is returning value to investors.  It is often used with companies that do not pay dividends.
    • The ROE is calculated by dividing the Net Income for time period by the average equity during that same period.  The average equity is the average of the value of the equity at the start and end of the time period.
    • ROE can be increased by increasing assets without increasing liabilities, decreasing liabilities without decreasing assets, or increasing Net Income without impacting assets and liabilities.
    • ROE is a good measure for the investment community.  When a company is going through major structural change because of acquisition or divestiture, watch the ROE closely to understand the impact of the changes.

Hints and Tips

  • Don’t fixate on one ratio.  A clever management team can manipulate that business so that one ratio looks good, but the business must be well run for all the ratios to look good. 
  • During times of business structural transition, watch closely what is happening on the balance sheet, the changes in assets, liability and equity can have a huge impact on ROA and ROE.
  • Watch the trends of each of these ratios.  A sudden shift is often caused by a structural change.  A negative trend is an indication of management not adapting to the industry and market realities.
  • The definition of a “high” or “low” ratio will vary significantly by industry.
Login to download
  • 00:03 Hi, this is Ray Sheen.
  • 00:05 I'd now like to talk with you about some of the return on ratios that are used for
  • 00:09 measuring business performance.
  • 00:11 One of the ways that we understand how all businesses operating.
  • 00:15 First to see ROS or Return On Sales.
  • 00:19 Return on sales is really another way of looking at profitability.
  • 00:23 The net income from the earnings statement is divided by the total revenue
  • 00:27 from the earnings statement.
  • 00:29 The result in percentage is the ROS.
  • 00:32 This is a measure of business profitability and business efficiency.
  • 00:36 We talk about a profitability measure in another module.
  • 00:39 At that time we said the profitability measures were often shown
  • 00:43 with a percentage such as gross margin or operating margin.
  • 00:46 The ROS is similar in nature, but is using the net income in the numerator.
  • 00:51 So this ratio tells us what percentage of the total revenue
  • 00:55 is actually turned into profit for the business.
  • 00:58 When the company wants to improve its ROS,
  • 01:00 it must either increase sales without a significant increase in cost.
  • 01:04 In that case both the numerator and the denominator in the ratio will increase by
  • 01:07 the same amount but since the numerator, the net income,
  • 01:10 is a smaller number it will be a much larger increase proportionally.
  • 01:15 The other approach would be to lower costs while holding sales at the same level.
  • 01:20 In this case the net income would be higher since it is calculated by
  • 01:23 subtracting cost from the revenue.
  • 01:25 With a higher net income in the same revenue the ROS would go up.
  • 01:30 The next ratio is the Return On Assets.
  • 01:34 This will use the net income from the earnings statement and
  • 01:36 divide that by the average total assets from the balance sheet
  • 01:40 over the period represented by the net income.
  • 01:43 This ratio is often used with companies that must operate with a large asset base
  • 01:47 such as utilities, railroads, and large manufacturers.
  • 01:51 This is a measure of asset efficiency.
  • 01:53 Is often tied to asset utilization.
  • 01:56 The more net income is created with the assets, the better the ratio.
  • 01:59 Of course, if an asset is not producing any value, it would suppress the ratio,
  • 02:04 since it would be counted in the asset base, but not generating any profit.
  • 02:08 The average total assets is determined by taking the total assets from the beginning
  • 02:12 of the earnings statement period, and the total assets at
  • 02:15 the end of the earning statement period and averaging those two values.
  • 02:20 Raising the net income with the same amount of assets, or
  • 02:22 achieving the same level of net income with fewer assets will improve this ratio.
  • 02:27 Keep in mind, we only use this ratio with industries that require a large asset
  • 02:31 base to operate.
  • 02:33 If there's a very small asset base, one tiny change in assets or
  • 02:37 net income can create a major change to the ratio.
  • 02:41 A final ratio I'd like to discuss is Return On Equity, or ROE.
  • 02:46 This ratio again uses the net income from the earning statement but
  • 02:49 this time we will use a different portion of the balance sheet,
  • 02:52 the equity portion of the liability and equity on the balance sheet.
  • 02:56 This is a measure for
  • 02:57 investors to determine the quality of an investment into the business.
  • 03:01 Because it's a ratio of the profits over the owner's value in the company,
  • 03:04 it could be used by investors to determine if the rate of return on investment in
  • 03:08 the company is adequate.
  • 03:10 Similar to the ROA, the average total equity is determined
  • 03:13 by considering the period represented by the net income and
  • 03:16 averaging the total equity at the start and end of that period.
  • 03:20 Raising the net income without changing the value of the equity would improve
  • 03:23 this ratio.
  • 03:24 Also, reducing the assets while holding the net income and the liabilities at
  • 03:29 the same level would shrink the equity portion of the balance sheet and
  • 03:32 raise this ratio.
  • 03:34 This is one of the reasons why companies will sometimes spin off a part of
  • 03:36 their business.
  • 03:38 One final caution when working with any of these ratios.
  • 03:41 The standard for what is a good value depends upon the industry and market.
  • 03:45 Be very careful comparing ratios across industries.
  • 03:48 The risk profile and long term industry dynamics can have a major effect
  • 03:52 on what is considered an acceptable ratio.
  • 03:56 So each of these ratios, ROS, ROA, and ROE,
  • 03:59 provide an indication of how well a business is being managed.
  • 04:03 ROS focuses on profitability, ROA on asset utilization, and ROE on investors return.

Lesson notes are only available for subscribers.

PMI, PMP, CAPM and PMBOK are registered marks of the Project Management Institute, Inc.

Gift this course