Return on Capital

returnReturn on Capital is a general term representing the return on investment and the return on equity that businesses use to analyze their earnings and to compare those earnings to other similar businesses. This can affect whether a bank or person will want to lend you money or invest in your business.

Part of the management of a small business is much like the management of a larger business – the proper mix of debt and equity that maximizes the Return on Investment (roi)  and shareholders’ wealth while reducing the cost of capital, like the interest or dividends that must be paid.

A part of efficient financial management concentrates on  important funding strategies and leverage to produce a good return on investment for the shareholders, even if you are the only shareholder.

Return on Equity and Return on Investment are similar and both are key measures of profitability, indicators of management effectiveness and efficiency.

Return on Equity is the net income divided by the shareholder’s equity. This  is the amount that the shareholder should expect to receive on his investment. Of course, some of this “return” must be retained to produce additional profits in the future. Return on Equity will vary from industry to industry. The higher the better!

Return on Investment is expressed in various ways depending upon how the investor wants to see the numbers. It is basically the Operating Income (what comes from actual operations) divided by Assets. Some analysts will use the Net income rather than Operating income, and they may use Assets less short term borrowings as the denominator. The analyst will be looking at it differently depending on whether they are considering lending or investing.

Generally a ROI of less than 10 percent is considered low, but there are many factors to consider when analyzing a set of financial statements. All industries will have a range that applies to their operations. Many times industry magazines, 20-20 group information and information from your accountant will provide you with the range you should attain.

Think like a large business when you are doing operating your small business; don’t overlook what the big businesses do in terms of their understanding of their numbers. And no matter how “Good” the numbers look, keep doing the formulae and spread sheets so you will have comparisons to evaluate if something has changed. These stats come in very handy when you are ready to sell or give up your business as well — a business with really good past records often sells for more than a business with less than adequate records.

At Vaughncpa, LLC, we can help you monitor and give suggestions for improving your Return on Equity, Return on Investment and other indicators of profitability.

 

Working Capital Ratio