Unformatted text preview: Return on common equity Return on common equity = (Net income – Preferred dividends)/ (average common shareholder’s equity) Common shareholder’s equity = Shareholder’s equity - Preferred Stock. 1 Return on common equity is often considered the most important ratio. See the Harvard case Why the most important? Investors want a return of profit on their investment. The long run US average return on common equity is right around 10 percent 2 This ROCE is different from most ratios in that it is compared with a national average as well as an industry average. Why? Industries may vary greatly, but all have to be profitable. Internet companies were thought to be an exception to this rule in the late 1990s, but they were not. 3 How to analyze ROCE? Book, case tell the same story. Break ROCE into the product of three terms: ROCE = (net income – preferred dividend)/sales times sales/average total assets times average total assets/average common shareholder’s equity = profit margin X asset turnover X financial leverage 4 return on assets Similar to ROCE in that it is an overall profitability measure. ROA = (net income + (1 – tax rate) interest expense + minority interest in income)/ average total assets 6 Analysis is the same approach as ROCE. To gain insight into trends in ROA we break it down into components ROA = (net income + (1 – tax rate) X interest expense + minority income)/sales X sales/average total assets. We lose the leverage factor. This makes sense since we are placing all investors into one group. 7 ROA is the better choice when we want to eliminate the leverage factor in the analyis – anti-trust/ monopoly analysis. ROCE is the better choice when we have the perspective of the company owners, the common shareholders. In financial statement analysis we usually have the perspective of common shareholders, the common stock. 8 Summary 1. The return on equity is the single most important ratio. The long-run US return on common equity is 10 percent. 2. The return on equity of any firm has a tendency to evolve toward the long-run U.S. average of 10 percent. 9 3. The economics of financing: debt, preferred stock, and equity Common Equity Governance Common shareholders control the company Distribution Top priority in Second priority Lowest priority case of in case of in case of financial financial financial difficulties difficulties difficulties Corporate Tax Interest Preferred Dividends not considerations Deductible Dividends not deductible deductible 10 Debt Preferred Stock Leverage Leverage refers to debt financing or a high ratio of assets to common shareholder’s equity. Highly leveraged firms have more debt and riskier (more likely to go bankrupt). A key point with leverage is that leverage magnifies good results and bad results: Good results become great results Poor results become very poor results. Example: International Widgets
11 Summary 1. Leverage refers to debt financing/High ratio of Assets to Equity 1. Leverage magnifies both good and bad results. 13 1. Short term solvency ratios Banks emphasize these ratios when considering short-term loans (1 year or less). Current ratio = Current assets/Current liabilities. Banks like to see a high ratio. Quick ratio = (Cash + Marketable securities + Receivables)/Current liabilities. Inventory may be suspect. Banks like to see a high ratio. Operating cash flow to Current Liabilities ratio = Cash flow from operations/Current liabilities Banks, of course, like to see a high values of these ratios.
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