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Evaluating Financial Performance
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Evaluating Financial Performance
Return on Equity
Why use ratios?
It has been said that you must measure what you expect to manage and accomplish. Without measurement, you have no reference to work with and thus, you tend to operate in the dark. One way of establishing references and managing the financial affairs of an organization is to use ratios. Ratios are simply relationships between two financial balances or financial calculations. These relationships establish our references so we can understand how well we are performing financially. Ratios also extend our traditional way of measuring financial performance; i.e. relying on financial statements. By applying ratios to a set of financial statements, we can better understand financial performance.
Calculating Return on Equity
For publicly traded companies, the relationship of earnings to equity or Return on Equity is of prime importance since management must provide a return for the money invested by shareholders. Return on Equity is a measure of how well management has used the capital invested by shareholders. Return on Equity tells us the percent returned for each dollar (or other monetary unit) invested by shareholders. Return on Equity is calculated by dividing Net Income by Average Shareholders Equity (including Retained Earnings).
EXAMPLE — Net Income for the year was $ 60,000, total shareholder equity at the beginning of the year was $ 315,000 and ending shareholder equity for the year was $ 285,000. Return on Equity is calculated by dividing $ 60,000 by $ 300,000 (average shareholders equity which is $ 315,000 + $ 285,000 / 2). This gives us a Return on Equity of 20%. For each dollar invested by shareholders, 20% was returned in the form of earnings.
SUMMARY — Return on Equity is one of the most widely used ratios for publicly traded companies. It measures how much return management was able to generate for the shareholders. The formula for calculating Return on Equity is:
Net Income / Average Shareholders Equity
Components of Return on Equity
Return on Equity has three ratio components. The three ratios that make up Return on Equity are:
Profit Margin = Net Income / Sales
Asset Turnover = Sales / Assets
Financial Leverage = Assets / Equity
Profit Margin measures the percent of profits you generate for each dollar of sales. Profit Margin reflects your ability to control costs and make a return on your sales. Profit Margin is calculated by dividing Net Income by Sales. Management is interested in having high profit margins.
EXAMPLE — Net Income for the year was $ 60,000 and Sales were $ 480,000. Profit Margin is $ 60,000 / $ 480,000 or 12.5%. For each dollar of sales, we generated $ .125 of profits.
Asset Turnover measures the percent of sales you are ...
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