Most successful businesses earn a return on average total assets of, perhaps, 15% or more. At this writing, businesses’ must pay interest rates of between 6% and 12% in ‘ order to borrow money. if a business is well managed and has good future prospects, management should be able to earn a return on assets that is higher than the company’s cost of borrowing.
The rectum on equity Is net Income The return on assets measures the efficiency with which management has utilized the assets under its control, regardless of whether these assets were financed with debt or requirement capital.
The return on equity ratio, in contrast, looks only at the return earned by management on the stockholders’ investment-that is, on owners’ equity.- The return’ to stockholders is net income. which represents the return from all sources. both operating ,and nonoperational. Thus return on equity is computed as follows:To illustrate, let us again turn to the 2001 financial statements of Computer Barn. In 2001, the company earned.net income of $72,000.
The year-end balance sheet (page 6.18) shows total stockholders’ equity of $420,000. To, enable us to complete our computation, we will assume that the stockholders’equity at the beginning of the ‘year amounted to 5380,000. Therefore, the average stockholders’ equity for the year amounts to $400,000 [($380,000 + $420,(00) -:-2]. The return on stockholders’ equity in 2001 is 18%, computed as follows:Transitionally, stockholders have expected to earn an average annual return of 12% or more from equity investments in large, financial strong companies. Annual returns on equity of 30% or more are not uncommon, especially in rapidly growing companies with ,new or brightly successful products.
The return on equity may be higher or lower than the overall return on assets, depending on how the company’ has financed its assets and on the amounts of its non-operating revenue and expenses. A company that suffers a net loss provides its stockholders with a negative return on stockholders’ equity.