How to calculate return ratios?

Return on total assets (ROA), a significant measure of entrepreneurial effectiveness, is a combination of the sales-profitability measure and an asset-utilization ratio. By calculating each component of the measure, it is possible to analyze more precisely the origins of the company’s profitability: marketing or production. The two components of this calculation, sometimes called the Dupont formula because it was developed by the management of that company into an extensive analysis system, are:

Return on Assets = (Income / Sales (or Revenue) x (Sales / Average Total Assets) = Income /
Average Total Assets

When the component ratios are calculated for several years, it is easy to determine if profit margin (marketing) or asset turnover (operating efficiency) is having the greater impact on the return on the company’s assets.

Although the Return on assets helps identify the relative contributions of the marketing and the production activities, it does not reflect the effects of financing on the stockholders’ profitability. This is provided by the return on equity (ROE) ratio, which is the Return on Assets times the leverage-on-equity ratio:

Return on Equity = (Income / Assets) x (Assets / Equity)

KEY POINT: In general terms, the sales-profitability ratio and its sub-components are measures of marketing activity. The asset-utilization ratios measure operating management. The capital-leverage ratios are the finance department’s responsibility. The return-on-equity ratio is a measure of the corporate effectiveness. The ROE, for a group of companies in diverse industries, should have much less variation than the individual components of the ratio because the equity investors ultimately price the return based on the risk. If returns are unusually high for the risk, more funds will flow to that sector of the economy, depressing the return (price competition). If returns are low, funds are withdrawn until the returns finally improve.

Many ratios have been developed by trade associations, credit reporting agencies, security analysts, and other users of financial statements. Some ratios are peculiar to certain industries such as transportation, utilities, and insurance. Others are of a more general nature. If the analyst can find out which relationships are important to measure, a ratio can be developed to measure them.