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In this lesson, I'll discuss how to calculate return on equity and return on assets, two important ratios when you're considering the financial health of a company. A publicly traded company has one goal: to maximize a shareholder value. The bottom line measure of a firm shareholder value is its equity, which is Total Assets minus Total Liabilities. Comparing the relationship between a company's earnings to its equity provides a clear picture of the company's ability to generate returns for its stockholders. You divide the company's net income, which is its income after taxes by its shareholder's equity.
So here in the worksheet, I have two entries, one is the Net Income After Taxes and the other is the Shareholder's Equity. So to divide the two, type equal to start the formula and we have Net Income After Taxes in cell B5, divide that by Shareholder's Equity in B6 and press Enter and there you have your ratio of 0.11 for the return on equity. You can compare this result to other companies in which you're considering investing, so you can determine which company has provided a better result for its shareholders. And just as a general basis for comparison, most firms in the S&P 500 generate ROE ratios of between 10% and 15%.
You should also take into consideration a firm's Return on Assets. Companies need to make sure that their infrastructure, which includes their office buildings, computers and manufacturing systems, are of high enough quality to support the company's activities. It's important that companies not spend too much on their assets, as doing so cuts into profitability, but they should spend enough to ensure their infrastructure supports the operations. One measure you can use to determine how efficiently a company spends its money on assets is by calculating the Return on Assets ratio. To calculate the Return on Assets ratio, you divide a company's earnings before interest and taxes by the company's total assets.
So here we have those two values, the Earnings Before Income and Taxes and the Total Assets. So I'll divide earnings, B5/B6 and you have a ratio of 0.04. Comparing a company's Return on Assets ratio to those of other firms in the sector help you determine how efficiently the company employs its assets. Reductions in a company's Return on Assets ratio could indicate either economic opalescence, such as when a company's manufacturing system falls behind the technology curve or it could mean that the company just invested a significant amount of money in the new system and has yet to reap the benefits of the new technology.
As always, be sure to read a company's public filings to help you interpret the numbers included in those documents. You should compare a company's Return on Equity and Return on Assets ratios to determine how the company pays for its operations. When a company's Return on Equity is higher than its Return on Assets, it's usually an indication that the company finances its operations through sales of stock instead of taking on debt. If Return on Assets is higher than Return on Equity, then the opposite is true.
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