10 financial concepts you should master
Here is the final lesson in unwrapping essential financial concepts and how they will help you run your business.
Return on assets/equity
The return on assets ratio measures how effectively assets are working to generate profit, which is a critical factor for every business.
The return on assets ratio has a very simple formula. It’s net profit before tax times 100 divided by total assets.
Let’s say, for example, your company had a net income after tax of $60,000 and a total asset base of $1 million. Divide six million (60,000 times 100) by one million and the ratio is 6:1.
Generally speaking, the higher the ratio, the better the return on assets. That said, it has to be measured against other factors like risk, sustainability and reinvestment in the business.
The ratio can be compared to the return on assets generated by other companies in the same industry, but figures would vary from industry to industry.
Some companies – like telcos, mining companies and car manufacturers – use a lot of heavy equipment and are therefore asset heavy.
Other companies, like graphic artists and architects, might be lighter on assets.
As a general rule anything below five is regarded as asset heavy.
The return on equity basically tells us how much profit a company has earned compared to the total amount of shareholder equity on the balance sheet.
To put it in another way, it measures how profitably the company employs money raised from shareholders.
To calculate return on equity, take a year’s worth of earnings and divide that by the average shareholder equity for that year. That gives investors a picture of how good a job management is doing.
Accountants say anything above 15 per cent is regarded as a reasonable return on equity and anything below 10 per cent is regarded as poor.
A higher ROE is regarded as better because it means the company is more efficient about how it uses its equity.
It is generally regarded as better to compare ROE for companies within the same industry.