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Return on Investment: measures of performance

In the analysis of the return a particular investment is generating there are two measures that provide complementary and yet different appraisals. In a two part series we will look at how these measures provide some of the most important analysis of capital deployed and the efficiency of fund utilization.

Return on Total Assets (ROTA) and Return on Equity (ROE)

Back in November 2014 we provided an overview of ROE and also provided an online calculator to help you with the calculation. In this new post we expand on this material and in particular introduce the measure of ROTA (to be covered in next weeks tutorial).

These two measures provide a means analyzing the business from the perspective of the total capital employed in the business to generate the results that it does. While the second looks at the reward for the owners, with the equity placed into the business what return are the shareholders being rewarded with.

In the first of two tutorials on this material we work through examples to show how the performance measures are calculated and, more importantly, what do the measures mean and how should be used in business analysis.

Return on Equity (ROE)

Set out below is the source figures for the calculation of the ROE. The figure is always expressed as a percentage and reflects the return being generated from the funds shareholders have invested in the business through capital directly paid in and profits reinvested.

Statement of Financial Performance

Operating Sales 1,120,000
Operating Expenses 1,008,000
PBIT 112,000
Less: Interest Expense 20,000
PBT 92,000
Less: Income Tax 32,000
PAT 60,000
Less: Dividends Declared 24,000
Net Profit 36,000

 

Statement of Financial Position

Owners Equity 360,000
Current Assets 320,000
Less: Current Liabilities 240,000
Working Capital 80,000
Non-Current Assets 480,000
Non-Current Liabilities 200,000
Net Assets 360,000

Definitions:

PBIT = Profit Before Interest and Tax

PBT = Profit Before Tax

PAT = Profit After Tax

Calculation

ROE PAT 60,000 16.6%
Owners Equity 36,000

Analysis

Out of the two measures, ROE and ROTA, the former is perhaps one of the most important figures in the assessment of investment return and in particular for publicly listed firms their respective share price. Other than a boasting figure for executives around lunches and a key driver of performance related bonuses, for the company itself it strengthens its ability to attract and retain capital funding. And, all other things being equal, should also attract cheaper debt financing.

With the ability to attract and hold equity and debt funding a business then has the means to utilize this capital through which it can then grow its revenues and profits. As long as the executive is able to continue or improve its efficiency in the utilization of this additional funding the returns to shareholders, in particular with increased leverage through greater debt funding, will improve and grow.

Like many of these measures of financial efficiency it cannot only be applied at the individual company or business level but also to the wider economy. The efficiency in which a country can utilize its capital, physical, human and money, is reflected in its economic growth and strength. You will find over history those countries that have been able to gain the greatest leverage in deployment of capital has been able to grow in economic and political power. Where as those countries that have been wasteful in this deployment of economic resource, and often despite the bounty of it, have suffered lower levels of employment, standards of living, political stability and wider geo-political influence.

Next week we will be looking at ROTA and how this measure complements the ROE and the efficiency in capital deployment. As always we welcome any feedback you have about our site. Please provide comment below or use the Contact Us page.

 

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