﻿ ﻿Ratio Analysis - Financial Management - QuickBooks 2016 All-in-One For Dummies (2016)

# QuickBooks 2016 All-in-One For Dummies (2016)

### Financial Management  See www.dummies.com/extras/quickbooks2016aio for a compendium of financial ratios.

Contents at a Glance

1. Chapter 1: Ratio Analysis

1. Some Caveats about Ratio Analysis

2. Liquidity Ratios

3. Leverage Ratios

4. Activity Ratios

5. Profitability Ratios

2. Chapter 2: Economic Value Added Analysis

1. Introducing the Logic of EVA

2. Seeing EVA in Action

3. Reviewing Some Important Points about EVA

5. Presenting Two Final Pointers

6. And Now, a Word to My Critics

3. Chapter 3: Capital Budgeting in a Nutshell

1. Introducing the Theory of Capital Budgeting

2. Calculating the Rate of Return on Capital

3. Measuring Liquidity

5. What Does All This Have to Do with QuickBooks?

### Ratio Analysis

In This Chapter

· Introducing examples of and caveats about ratio analysis

· Analyzing liquidity ratios

· Analyzing leverage ratios

· Analyzing activity ratios

· Analyzing profitability ratios

Numbers from your financial statements make more sense when you can compare them with other numbers and external benchmarks. In this chapter, I talk about how you can perform this sort of analysis, which is called ratio analysis. Even if you’re not a numbers person, you can use ratio analysis to your benefit. Ratio analysis is easy to apply, and it enables even the nonquantitative type of person who uses it to better understand the information in financial statements.

Let me give you a quick example of ratio analysis. One particularly useful ratio is the gross margin percentage, which is your gross margin divided by your total sales. Although this ratio may not seem useful at first blush, it can be very valuable.

For example, if you compare your gross margin percentage for this year with last year and see a decline, you know that this isn’t good. Less gross margin means less money for operating expenses, interest expenses, and profits. On the other hand, if you compare your declining gross margin percentage with a competitor’s and see that your competitor’s gross margin percentage is declining even more rapidly than yours, well, you know that’s good. This comparison shows that you may actually be in pretty good shape: At least you aren’t hurting like your competitor.

These are the sorts of insights that ratio analysis can provide. They enable you to put numbers from your income statement and balance sheet in context.

This chapter steps through the formulas, provides examples, and gives useful guidelines for 16 common financial ratios. I group the ratios into four categories: liquidity ratios, leverage (or debt) ratios, activity ratios, and profitability ratios.

Before you go any further in using ratio analysis to draw conclusions, consider these two warnings about it:

· The ratios are only as good as your inputs. Obviously, the more accurate your QuickBooks accounting records are, the more accurate any ratios that you calculate by using the numbers from your QuickBooks financial statements will be. This makes sense, right? Garbage in, garbage out. Even if your financial records are garbage free, if they contain something just slightly wacky, such as an unusually large transaction that skews all the numbers, your financial ratios aren’t as good as they might be.

· Ratios become relevant through comparison. Your financial ratios become most relevant — I’ve already hinted at this — when they compare your numbers with those of your competitors, the numbers that you had a year ago, and the numbers that a bank loan agreement specifies are necessary for you to continue achieving in order to be in the bank’s good graces. A comparison with other ratios is crucial because often, your numbers are just numbers if they can’t be compared with external benchmarks. Industries commonly prepare reports that summarize financial ratio information for other firms in the industry. For example, early in my career, I was the controller of an electronics manufacturing firm. Our industry group, the American Electronics Association, prepared a financial ratio survey. With this financial ratio survey, I was able to easily compare the financial ratios of the firm I worked at with the financial ratios of other firms. Currently, as a CPA, I find it very useful that the Texas Society of CPAs and American Institute of Certified Public Accountants prepare an annual financial study that shows financial ratios for CPA firms around the United States. You probably also operate in an industry that has a professional association. Keep your eyes and ears open to the possibility that this group or association prepares and distributes reports that include financial ratios. Such a report can be a useful tool to you as you manage your firm.

Note: When you compare your firm with other firms by using financial ratios, you compare it with firms of a similar size. It usually doesn’t make sense to compare, for example, a million-dollar business with a billion-dollar business. Some of the QuickBooks financial statements provide simple financial ratios automatically. For example, you can add the gross margin percentage (and other percentage measures) to the standard income statement and to the standard balance sheet.

Liquidity Ratios

Liquidity ratios measure how easily and comfortably a firm can pay its immediate financial obligations and exploit immediate short-term financial opportunities. For example, everything else being equal, the firm that’s sitting on a large hoard of cash can more easily pay its bills and can take advantage of great opportunities that pop up. (For example, if a competitor gets into trouble and wants to sell valuable assets at fire-sale prices, a very liquid firm with great gobs of cash can more easily exploit such an opportunity.)

Current ratio

The current ratio liquidity measure compares a firm’s current assets with its current liabilities. A firm’s current assets include cash, inventory, accounts receivable, and any other asset that can (or will be) quickly turned into cash. Most small businesses don’t have much in the way of other current assets, although they may have some, such as short-term investments. Current liabilities include bills that must be paid in the coming year, such as accounts payable, wages payable, taxes payable, and — if you’re borrowing money on a long-term basis, such as through bank loans — the principal portions of the coming year’s payment on a loan.

The following is the exact formula used to calculate the current ratio:

current assets/current liabilities

The simple balance sheet shown in Table 1-1 gives you an example of how this current ratio formula works. As Table 1-1 shows, this firm’s current assets equal \$50,000. The firm’s only current liability is \$20,000 of accounts payable. (For purposes of this discussion, I’m assuming that this firm has no other current liabilities.)

Table 1-1 A Simple Balance Sheet

 Assets Cash \$25,000 Inventory 25,000 Current assets \$50,000 Fixed assets (net) 270,000 Total assets \$320,000 Liabilities Accounts payable \$20,000 Loan payable 100,000 Owner’s equity S. Nelson, capital 200,000 Total liabilities and owner’s equity \$320,000

To calculate the current ratio of the firm described by the balance sheet in Table 1-1, you use the following formula:

\$50,000/\$20,000

This formula returns the value 2.5. Therefore, the value 2.5 is this firm’s current ratio.

Here’s a general guideline concerning current ratios: A firm’s current ratio should be a value of 2 or higher. In other words, the firm’s current assets should be double or more than double the firm’s current liabilities.

Acid test ratio

Also known as the quick ratio, the acid test ratio is a more severe measure of a firm’s liquidity. However, it serves the same general purpose as the current ratio. The acid test ratio indicates how easily a firm can meet its current financial obligations and exploit any financial opportunities that pop up.

The following formula is used for calculating the acid test ratio:

(current assets - inventory)/current liabilities

For example, in the case of the business described by the balance sheet shown in Table 1-1, you use the following formula to calculate the acid test ratio:

\$25,000/\$20,000

This formula returns the value 1.25. Therefore, the value of 1.25 is this firm’s acid test ratio.

Here’s a guideline for acid test ratio: A firm’s acid test ratio should be a value of 1 or higher. In other words, the current assets after you subtract the inventory should provide enough money to pay the current liabilities.

Leverage Ratios

Leverage ratios measure how much debt a firm carries and how easily a firm pays the interest expenses of carrying that debt. Leverage ratios are important for an obvious reason. Typically, a firm mostly financed with debt needs to continue to borrow in order to stay in business. (If this doesn’t make sense, think about what happens if a bank won’t extend a loan or won’t refinance a mortgage to a firm that’s heavily dependent on debt!)

What’s more, a firm that carries a lot of debt typically also spends a lot of money on interest expense. The heavy interest expense means that it’s especially important for such a firm to have adequate operating income. Operating income is the income available to pay interest and other profits. A firm with a lot of operating income relative to its interest expense doesn’t really have much of a problem paying the interest — and this is true even if operating income declines or decreases. In contrast, a firm with only very modest operating income relative to its interest expense quickly gets into trouble if the operating income decreases.

Debt ratio

The debt ratio simply shows the firm’s debt as a percentage of its capital structure. The term capital structure refers to the total liabilities and owner’s equity amount. For example, in the case of the balance sheet shown in Table 1-1, the capital structure totals \$320,000. Not coincidentally, the total liability and owner’s equity amount (\$320,000) equals the total assets amount (\$320,000). This makes sense if you think about it a bit. A firm funds its assets with its capital. Therefore, the total assets always equal the total capital structure.

The formula for calculating the debt ratio is a simple one:

total debt/total assets

Using numbers from the simple balance sheet shown in Table 1-1, for example, the debt ratio can be calculated as follows:

\$120,000/\$320,000

This formula returns the debt ratio of 0.375. This indicates that 37.5 percent of the firm’s capital comes from debt.

No guideline exists for debt ratio. Appropriate debt ratios vary by industry and by the size of the firm in an industry. In general, small firms that use QuickBooks probably want to show lower debt ratios than larger firms do. Small firms, in my experience, see their operating income fluctuate more wildly than large firms do. Because of that fluctuation, carrying and servicing such debt are more problematic. Lower debt, therefore, is probably better. This makes sense, of course, so I’m not telling you anything that you don’t already know.

Debt equity ratio

A debt equity ratio compares a firm’s long-term debt with a stockholder’s equity or owner’s equity. Essentially, the debt equity ratio expresses a firm’s long-term debt as a percentage of its owner’s equity. Stockholder’s equity is synonymous with owner’s equity and, in the case of a sole proprietorship, with a sole proprietor’s capital account.

The following is the formula used to calculate a debt equity ratio:

long-term debt/stockholder’s equity

By using the example balance sheet shown in Table 1-1, you can calculate the debt equity ratio by using this formula:

\$100,000/\$200,000

This formula returns the debt equity ratio of 0.5. Therefore, this firm’s long-term debt equals 0.5, or 50 percent of its owner’s equity.

I can’t really give you a guideline for a debt equity ratio. You simply compare your debt equity ratio with the debt equity ratios of similar-size firms in your industry. As is the case with the debt ratio previously described, all other things being equal, the less long-term debt you carry, the better.

Times interest earned ratio

The times interest earned ratio indicates how easily a firm pays interest expenses incurred on its debt. To calculate the times interest earned ratio, you need an income statement that shows both operating income and interest expense. Table 1-2 provides this information.

Table 1-2 A Simple Income Statement

 Sales revenue \$150,000 Less: Cost of goods sold 30,000 Gross margin \$120,000 Rent 5,000 Wages 50,000 Supplies 5,000 Total operating expenses 60,000 Operating income 60,000 Interest expense (10,000) Net income \$50,000

The following formula is used for calculating the times interest earned ratio:

operating income/interest expense

If you look at the income statement shown in Table 1-2, you see that operating income, which is the income that a firm has before paying its interest expense, equals \$60,000. Interest expense shows up as \$10,000. Therefore, you calculate the times interest earned ratio by using this formula:

\$60,000/\$10,000

This formula returns the times interest earned ratio of 6. Therefore, the firm’s operating profits pay the interest expense six times over.

No standard guideline exists for the times interest earned ratio. Obviously, however, the times interest earned ratio should indicate that a firm can easily pay its interest expense. It would be sort of scary, if you think about it, for the operating income to be only a little bit greater than the firm’s interest expense. Such a situation would indicate that a modest drop in operating income would make paying interest expense impossible.

Fixed-charges coverage ratio

The fixed-charges coverage ratio resembles the times interest earned ratio. The fixed-charges coverage ratio calculates how easily a firm pays not only its interest expenses, but also any principal payments on loans and any other payments that the firm is legally obligated to make.

The fixed-charges coverage ratio uses the following formula:

income available for fixed charges/fixed charges

Returning to the example business described by the balance sheet shown in Table 1-1 and the income statement shown in Table 1-2, suppose that the \$5,000 of rent shown in the income statement is actually a fixed charge because the firm is renting space on a long-term lease. Further suppose that for the purpose of this ratio, although it doesn’t show up on the income statement, the \$100,000 loan that shows up on the balance sheet requires an annual \$5,000 in principal payments.

In this case, this firm is obligated to pay fixed charges as summarized in Table 1-3. In total, then, fixed charges for this firm equal \$20,000 a year.

Table 1-3 Fixed-Charges Calculation

 Interest (as shown in Table 1-2) \$10,000 Rent (as shown in Table 1-2) 5,000 Principal (as mentioned in text) 5,000 Fixed charges \$20,000

The other input needed to calculate the fixed-charges coverage ratio is the income available for these fixed charges. Table 1-4 shows you how to calculate the income available for fixed charges. You start with the operating income, which equals \$60,000, as shown in Table 1-2. (Remember that the operating income is the income before paying interest expense.) You must add to the operating income any fixed charges included in the income statement. In this case, the rent turns out to be a fixed charge. Therefore, you need to add the \$5,000 of rent needs to the operating income in order to get income available for fixed charges. As Table 1-4 shows, the income available for fixed charges equals \$65,000.

Table 1-4 Income Available for Fixed Charges

 Operating income \$60,000 Add-back of rent 5,000 Fixed charges \$65,000

With the two needed inputs, you can calculate the fixed-charges coverage ratio by using this formula:

\$65,000/\$20,000

This formula returns a fixed-charges coverage ratio of 3.25, which indicates that the firm generates slightly more than three times as much income as needed to pay its fixed charges.

No guideline exists to specify what your fixed-charges coverage ratio should be. In fact, it’s particularly difficult to get the information necessary to think about fixed-charge coverage ratios because fixed charges don’t clearly appear in the standard set of simple financial statements. One of the things that make financial statements (that are prepared in accordance with generally accepted accounting principles) so useful is that the fixed-charges information is usually disclosed in little footnotes that appear at the end of the financial statements.

Activity Ratios

Activity ratios provide an indication of how efficiently a firm runs its operations. For example (all other factors being equal), a firm that keeps a very modest amount of inventory is in better shape than a firm that has to keep (store, manage, warehouse, insure, and so forth) a bunch of inventory. That makes sense, right? Dell Computer, as you may know, keeps only a few days’ worth of inventory on hand. In other words, it sells out its current inventory holdings every few days. Other computer manufacturers — especially in the past — kept weeks’ and even months’ worth of inventory. Comparing the two examples, which is more efficiently and more leanly managing its inventory? Which has the minimal investment tied up? Which isn’t suffering or paying the price of warehousing all that extra, quickly obsolete inventory? The answer is Dell, obviously. So, predictably, Dell’s activity ratios look really good compared with those of its competitors.

Activity ratios, in essence, measure how well a firm uses its assets. If a firm makes super-efficient use of its factory, for example, that efficiency shows up in its activity ratios. And if a firm runs lean and mean, that leanness and meanness show up in its activity ratios.

Inventory turnover ratio

The inventory turnover ratio measures how many times in an accounting period the inventory balance sells out. The formula is as follows:

cost of goods sold/average inventory

In the example business described by the balance sheet in Table 1-1 and the income statement in Table 1-2, you can use the following formula to calculate the inventory turnover:

\$30,000/\$25,000

This formula returns the inventory turnover ratio of 1.2. Technically, you shouldn’t use just an ending inventory balance, which is what appears in Table 1-1. You should use an average inventory balance. You can calculate an average inventory balance in all the usual, common-sense ways. For example, you can use the inventory balance both from this year’s balance sheet and the previous year’s balance sheet and then average them.

The inventory turnover period, as you may have noticed, depends on the period measured in the income statement. If the income statement is an annual statement and, therefore, the cost of goods sold amount is an annual cost of goods sold amount, an inventory turnover ratio of 1.2 means that a firm sells 120 percent of its inventory balance in a year. If the inventory turnover ratio uses the cost of goods sold amount reported in a monthly income statement, the inventory turnover period is a month. For example, with a monthly cost of goods sold amount, a firm with a 1.2 inventory ratio sells 120 percent of its inventory in a month.

No guideline exists for inventory turnover ratios. A good inventory turnover ratio depends on what your competitors are doing within your industry. If you want to stay competitive, you want an inventory turnover ratio that at least comes close to your competitors’ ratios. Dell’s competitors, to make a long, sad story short, found out the hard way not to compete with a company that turns around inventory much more quickly than they can. (Imagine soft, sad violin music playing in the background… .)

Days of inventory ratio

The days of inventory ratio resembles the inventory turnover financial ratio; it estimates how many days of inventory a firm is storing. The ratio uses the following formula:

average inventory/(annual cost of goods sold/365)

For example, the simple balance sheet shown in Table 1-1 shows inventory equal to \$25,000. Assume that this also equals the average inventory that the firm carries. In order to calculate the daily sales, you take the cost of goods sold number reported in the annual income statement shown in Table 1-2 and divide it by 365 (the number of days in a year). Putting these numbers together in the formula just introduced, the math looks like this:

\$25,000/(\$30,000/365)

This formula returns the value 304 (roughly). This value means that this firm is carrying roughly 304 days of inventory. Stated another way, this firm would require 304 days of sales to sell its entire inventory.

As is the case with the inventory turnover ratio, you don’t see generalized rules about what is an acceptable number for days of inventory. The general rule is that you turn around your inventory just as quickly as your competitor does.

I return to the case of Dell Computer because it’s so instructive — even if scary — to most of us. Dell sells out its inventory in a few days. Dell’s competitors were taking months to sell out their inventory. In an industry in which inventory was quickly becoming obsolete and was very expensive to start with, think of the competitive disadvantage that Dell’s competitors suffered by having to carry inventory for months longer than Dell did. Is it any wonder that many of Dell’s competitors got into trouble? The lesson of Dell applies to many folks who run or advise businesses that carry inventory. Inventory turnover and days of inventory ratios need to be watched carefully and compared with those of other firms of the same size in the same industry.

Average collection period ratio

The average collection period ratio shows how long it takes for a firm to collect on its receivables. You can think about this ratio as being a measure of the quality of a firm’s credit and collection procedures. In other words, this ratio shows how smart a firm is about deciding to whom to extend credit. This ratio also shows how effective a firm is in collecting from customers.

The average collection period ratio formula looks like this:

average accounts receivable/average credit sales per day

The balance sheet shown in Table 1-1 doesn’t show an average accounts receivable balance. The income statement shown in Table 1-2 also doesn’t break out sales into credit and cash components. Therefore, let me introduce another example into the text. Suppose that in the business you run, the average accounts receivable is \$60,000. Further suppose that your average credit daily sales equal \$1,000. Using the formula just given, you can calculate the average collection period as follows:

\$60,000/\$1,000

This formula returns the value 60. In this case, your business has 60 days of sales in accounts receivable.

The guideline about the average collection period is that it should tie to your payment terms. If your average number of days of credit sales in accounts receivable equals 60, for example, your payment terms should probably be something like net 60 days (which means that customers are supposed to pay you in 60 days or less). Your average collection period, in other words, should show that most of your customers are paying on time. Remember that some of your customers will pay early, and obviously, some of your customers will pay a bit late. You hope that on average, customers pay on time.

Fixed-asset turnover ratio

The fixed-asset turnover ratio quantifies how efficiently a firm employs its fixed assets. Predictably, this financial ratio is most useful when a firm has a lot of fixed assets: real estate, equipment, and so forth.

The fixed-asset turnover ratio uses the following formula:

sales/fixed assets

Based on the numbers supplied by the balance sheet shown in Table 1-1 and the income statement shown in Table 1-2, you can calculate the following fixed-asset turnover ratio:

\$150,000/\$270,000

This formula returns the value of 0.556. In a nutshell, this ratio says that this firm requires \$270,000 of fixed assets to produce \$150,000 of sales — or, more specifically, that the firm produces sales equal to roughly 56 percent of its fixed assets.

As is the case with many of these financial ratios, no guideline exists that you can use to determine a good fixed-asset turnover ratio. You compare your fixed-asset turnover ratio with those of firms of a similar size in your industry.

Total assets turnover ratio

The total assets turnover ratio also measures how efficiently you’re employing your assets. This ratio is probably more appropriate for a firm that doesn’t have a lot of fixed assets but still wins or loses at the game of business based on how well it manages its assets.

The total assets turnover ratio formula is as follows:

sales/total assets

Here’s a formula that calculates the ratio by using the financial data from Tables 1-1 and 1-2, shown earlier. If the total sales equal \$150,000 and the total assets equal \$320,000, the following formula makes the calculation:

\$150,000/\$320,000

This formula returns the ratio 0.469, which means that the firm generates sales equal to roughly 47 percent of its total assets.

The total assets turnover ratio that you calculate for your business can’t be compared with some external benchmark or standardized rule. You compare your ratio with the same ratio of similar-size businesses in your industry. Obviously, your main consideration is whether you’re efficiently using your assets to produce sales relative to those of your competitors. The more sales you can produce with a given level of assets, the better off your business is.

Profitability Ratios

Profitability ratios analyze a firm’s profitability. In a sense, profitability ratios are the most important ratios that you can calculate. They typically provide terribly useful insights into how profitable a firm is and why.

For example, one particularly important profitability ratio is the gross margin percentage, which expresses gross margin as a percent of sales. As discussed in Book VI, Chapter 1, you can calculate a firm’s break-even point simply by dividing the firm’s fixed costs by its gross margin percentage.

Gross margin percentage

Also known as the gross profit margin ratio, the gross margin percentage shows how much a firm has left over after paying its cost of goods sold. The gross margin is what pays the operating expenses; financing expenses (interest); and, of course, the profits.

The gross margin percentage ratio uses the following formula:

gross margin/sales

For example, using the data from Table 1-2 (shown earlier), you can calculate gross margin percentage as follows:

\$120,000/\$150,000

This formula returns the value of 0.8, meaning that gross margin equals 80 percent of the firm’s sales.

No guideline exists for what a gross margin percentage should be. Some firms enjoy very high gross margins. Other firms make good money even though the gross margin percentages are very low. In general, of course, the higher the gross margin percentage, the better. I need to make one cautionary statement here: In my humble opinion, small businesses should enjoy high gross margin percentages. I think it’s common to assume that a small business can get away with a lower gross margin percentage than some large competitors can. However, in my experience, that isn’t really true. Gross margin percentages should be higher for small businesses because small businesses often can’t get the economies of scale that large businesses can get. A low gross margin percentage may work just fine for Walmart, for example. However, it’s tough for a small retailer to work with such a small gross margin percentage.

Operating income/sales

In the case of the business shown earlier in Table 1-2, where operating income equals \$60,000 and sales equal \$150,000, you calculate the net operating margin percentage by using this formula:

\$60,000/\$150,000

This formula returns the value 0.4. In other words, you see a 40 percent operating margin, which indicates that a firm’s operating income equals 40 percent of its sales.

No guideline exists for what a net operating margin percentage should be. Your main consideration, which you’ll probably find yourself repeating in your sleep after reading it so much in this book, is that you want to be competitive. You want your operating margin percentage to be close to or better than those of your competitors. That parity (or superiority) enables you to stay competitive.

Profit margin percentage

The profit margin percentage works like the net operating margin percentage. It expresses the firm’s net income as a percentage of sales, as shown in the following formula:

net income/sales

In the case of the business described by the income statement shown in Table 1-2, the net income equals \$50,000, and sales equal \$150,000. This firm’s profit margin percentage, therefore, can be calculated with the following formula:

\$50,000/\$150,000

This formula returns a financial ratio of 0.33. This indicates that the firm’s net income equals roughly 33 percent of its sales.

Return on assets

The return on assets shows the return that the firm delivers to stockholders and the interest that the firm pays to lenders as the percentage of the firm’s assets. Some businesses use return on assets to evaluate the business’s profitability. (Banks do this, for example.)

The actual formula is

(net income + interest)/total assets

In the case of the example business described earlier in Tables 1-1 and 1-2, the net income equals \$50,000. Interest expense equals \$10,000. Total assets equal \$320,000. The formula to calculate this firm’s return on assets is

(\$50,000 + \$10,000)/\$320,000

This formula returns the value 0.188. This value indicates that the firm’s return (including both net income and interest) on its assets is roughly 19 percent.

No guideline exists for what a return on assets ratio should be. The main consideration is, predictably, that the return on assets must exceed the capital charges on the assets.

In Book V, Chapter 2, I talk more about capital charges and how they relate to something called Economic Value Added analysis. Capital charges aren’t complicated to understand. The bottom line is that a firm needs to deliver a return on its assets that exceeds the funding sources cost for those assets. In other words, if (on average) the creditor and shareholders providing money to a firm want something less than, for example, 19 percent, and the firm can earn 19 percent as its return on assets, that’s really good. If, on the other hand, the return on assets percentage is 18.8 percent, but the funding sources for those assets cost 20 percent, well, that’s not so good. That firm is in trouble. The term capital charge just equals the sum of the minimum profit that shareholders require to invest their money in a firm and the interest charges that lenders require for the money that they’ve loaned to the firm.

Return on equity

The return on equity financial ratio expresses a firm’s net income as a percentage of its owner’s equity or shareholders’ equity. (Shareholders’ and owner’s equity are the same thing.)

The formula, which is deceptively simple, is as follows:

net income/owner’s equity

In the case of the example business described earlier in Tables 1-1 and 1-2, the net income equals \$50,000, and the owner’s equity equals \$200,000. This firm’s return on equity, therefore, can be calculated by using the following formula:

\$50,000/\$200,000

This formula returns the value of 0.25, which means that this firm’s return on equity is 25 percent — a number that’s probably pretty good.

No guideline exists for what is and isn’t an acceptable return on equity. However, I can make two useful observations about how you should interpret the return on equity ratio that you calculate:

· The return on equity ratio that you calculate needs to be at least as good as you deserve. Okay, that sounds circular. So think about it this way: If you’re investing money in your business, you deserve a return on that money. And that return needs to be reasonable compared with your other alternatives. If you can go out and invest money in a stock market mutual fund and get 10 percent, you shouldn’t be investing in things that deliver a return of less than 10 percent. That makes sense, right? Therefore, if you want to earn a 20 percent return on the money that you’ve invested in your own firm (by the way, a 20 percent return is a very reasonable return for a small business), you want to make sure that your return on equity (after you get going) exceeds this minimum return.

· The return on equity ratio hints at the sustainable growth rate that your firm can manage. This sounds complicated. However, you need to understand what sustainable growth is and how it ties back to the return on equity ratio. Sustainable growth is the growth rate that your business can sustain over a long period of time: three years, five years, ten years, and so on. If you don’t take money out of the business (other than your salary), and you reinvest the return on equity that the business generates, the return on equity ratio equals your sustainable growth. In other words, the example business described earlier in Tables 1-1 and 1-2 can grow on a sustained basis as fast as 25 percent.

Alternatively, suppose that the owners of the imaginary firm described in the financial statements in this chapter take half the equity money out of the business. Perhaps half the \$50,000 net income is distributed as a dividend to shareholders, for example. In this case, because only half the return on equity is reinvested, sustainable growth equals only half the return on equity percentage. If the return on equity percentage equals 25 percent, but the owners withdraw half the return (12.5 percent), the reinvested half of the return on equity percentage (12.5 percent) equals the sustainable growth rate. In other words, this business can grow on a sustained basis at 12.5 percent annually.

In my experience, this sustainable growth business makes intuitive sense to some people, but it just leads to head-scratching for other people. In case you’re in the head-scratching group, consider a couple more comments: Large businesses have another way to grow owner’s equity. A large business, such as Hewlett-Packard, can go out into the capital markets and raise money by issuing stock. In fact, the real reason for making a company public isn’t to make the owners rich, but to access the public’s capital markets. Those markets provide access to almost unlimited amounts of capital (that is, unless you pull an Enron or WorldCom by proving that you don’t really deserve access to the capital markets). In the case in which a firm can tap these capital markets for cash or funding, the sustainable growth rate formula gets more complicated. These capital markets provide another way to grow owner’s equity.