Management Efficiency Ratios
There are two efficiency ratios which I mention most often namely Return On Assets and Return On Equity. I view them under efficiency as it shows the management’s ability to generate a return based on the resources the managers have access to.
Return On Assets
This margin shows the ability of the management in generating a return proportional to the assets that the business owns. This margin reflects the management’s ability, or the business economics, in maximising returns for the firm given a limited amount of resources. However, for certain asset heavy businesses like electronics, it is inevitable that their return on assets will be low due to their asset-heavy nature.
Return On Equity
This margin shows the ability of management in generating a return on the shareholder’s equity or money put up by equity holders of the business. This also shows the ability of the management in turning the cash put into the business into returns to be distributed to shareholders. This margin can be unnaturally high due to the impact of leverage (borrowings and debt) and should be compared relative to the debt levels of the company. Below I illustrate the previous rather complex statement I made.
|Company Not-So-Smart||Net Income: 1 Million
Asset – 4 million
Shareholder’s Equity – 4 Million
Return On Equity: 25%
|Company Smarter||Assume 10% annual interest on loan
Net Income: 800,000
Asset – 4 Million
Bank Loan – 2 million (Used this 2 million to purchase 2 million in assets)
Shareholder’s Equity – 2 Million
Return On Equity – 40%