Here “turnover” is not a physical concept as it was when we spoke about Inventory Turnover. Remember: retained earn i ngs belong to the common shareholders. Once again, w hat is management providing the shareholders for their equity investment ? S hareholders are interested in earnings, as it is earnings, which are either paid out as dividends or retained, and that is what benefit s the shareholders. ROE may be a better tool (t h an ROA) for assessing a firm’s (equity) investment merits, because shareholders are most interested in net income as that will either be distribute d to them as dividends and/or added to retained earnings, which are “owned” by shareholders. ROA and Leverage (i.e., the extent to which a firm utilizes debt) are inter-related. We shall get a glimpse of this when we – soon – look into the DuPont model on the very next page. In addition, “ leverage ,” i.e., the use of debt ( OPM ), increases the firm’s financial, or solvency, risk. This is not guaranteed borrowing does not en sure in all instances that ROE > ROA. While ROA reflects the firm’s effectiveness in producing operating profits, or EBIT, the effective use of leverage, i.e., debt, can increase the firm’s ROE above its ROA. T he more debt there is, the less equity the more interest expense, the less net income. What kind of return is the firm able to produce on its equity? Equity is the result of, no t just the company’s past operating performance (EBIT) and its associated accumulation of retained earnings, but management’s capital structure decision s (i.e., the debt/equity ratio) when it had to raise capital in the past. They understand that for each dollar of equity invested, they will have a claim on the company’s net income, i.e., its dividends and (additions to) retained earnings. Why may two, otherwise identical companies, have different ROAs? Does one company manage better? Does it motivate its employees better? Are they better trained? Do they work harder or longer hours? Does it employ better technology?Ĭommon shareholders are most interested in ROE because that is what they get for their equity investment.
ROA may be a good tool to judge management’s operating performance and its “asset utilization, ” or how efficiently it exploits the firm’s assets. While many will use net income in the numer ator, EBIT is preferable in the sense that operating profits reflect what the assets produce, whereas net income is affected by the firm’s capital structure, i.e., interest expense and particularly taxes, and othe r possible items not directly associated with the firm’s actual business or “operations.” How well is a firm employing its assets? Return on Assets attempts to gauge this. The analyst should also check the firm’s Liquidity. A growing company may need a great deal of liquidity, in order to support growing sales, which growth would be reflected in growing inventory and accounts receivable. The company may have onerous obligations due to maturing debt and the need for replacement of long-term assets. One must also examine the solvency ratios, especially the TIE ratio. Too much of anything may not be good.Įven though the firm may have high profitability, it does not mean that its cash flow position is strong. Having inventory sitting around does no good.Ī question to ask is: Why has the firm accumulated cash and other current assets rather than investing in more productive, fixed assets? There must be a balance between liquidity on the one hand, and return (see below) on the other. This is because current assets, especially cash, produce no return. We can also agree that too high a current ratio may be unhealthy. In discussing liquidity ratios, we agreed that in order to manage liquidity risk the current ratio should be at least one. For example, gross profit margin = gross profits ÷ sales. Each of the foregoing data ( without the word “margin” ) may be divided by “Total Sales” and used cross-sectionally or longitudinally. Certainly, we are all interested in profitability.
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