Financial Projection Return Ratios

The financial projections template includes two important return ratios.

  1. Return on assets (Net income / Assets)
  2. Return on equity (Net income / Equity)

Return on Assets (ROA)

The return on assets ratio indicates the amount of profit the business makes as a percentage of its assets. As the assets are funded by a combination of liabilities (including debt), and the owners funds (equity), we can also say that the return on assets is the same as the return on the liabilities and equity funding used within the business.

The return on assets formula is as follows:

Return on assets = Net income / Assets

The return on assets ratio can also be calculated by using two of the key financial ratios from the financial projections template as follows:

ROA = Net income / Assets
ROA = Net income / Revenue x Revenue / Assets
ROA = Profitability ratio x Efficiency ratio

From this we can see that the return on assets depends on how good the business is at generating profit from its revenue (profitability), and how efficiently the business uses its assets to generate revenue (efficiency).

Real Life Return On Assets Examples

The return on assets ratio will vary from industry to industry, and therefore it is important when making comparisons to determine an industry return on assets based on financial statements of businesses similar to your own.

To illustrate the difference in the return on assets ratio from industry to industry, the following table sets out the calculation of the ratio based on the Apple income statement. and balance sheet, and the Amazon income statement and balance sheet.

Return on assets (ROA) comparison
Apple Amazon
Net income 37,037 274
Revenue 170,910 74,452
Assets 207,000 40,159
Profit margin ratio 21.67% 0.37%
Asset turnover ratio 0.826 1.854
Return on assets 17.90% 0.69%

Return on Equity (ROE)

The second return ratio in the financial projections template is the return on equity. The return on equity indicates the return the business makes on its equity, that is the return for the owners of the business.

Return on equity = Net income / Equity

The return on equity ratio can also be calculated by using the return on assets ratio calculated above, and the equity multiplier ratio (leverage) which is one of the 4 key financial ratios included in the template.

ROE = Net income / Equity
ROE = Net income / Assets x Assets/ Equity
ROE = Return on assets x Equity multiplier
ROE = Profitability ratio x Efficiency ratio x Equity multiplier

From this we can see that the return on equity funding is a function of the return on assets and the extent to which the business is leveraged by liabilities including debt finance (equity multiplier). Providing the business is profitable and the return the business is making is greater than the interest it has to pay on debt, the higher the level of liabilities, the higher will be the equity multiplier and the return on equity.

Real Life Return On Equity Examples

The return on equity ratio will vary from industry to industry, and therefore it is important when making comparisons to determine an industry return on equity based on financial statements of businesses similar to your own.

To illustrate the difference in the return on equity ratio from industry to industry, the following table sets out the calculation of the ratio based on the Apple income statement. and balance sheet, and the Amazon income statement and balance sheet.

Return on equity (ROE) comparison
Apple Amazon
Net income 37,037 274
Revenue 170,910 74,452
Assets 207,000 40,159
Equity 123,549 9,746
Profit margin ratio 21.67% 0.37%
Asset turnover ratio 0.826 1.854
Equity multiplier 1.675 4.121
Return on equity 29.99% 2.82%

In both cases, due to the effect of leverage, the return on equity is higher than the return on assets.

For simplicity, the two return ratios above and in the financial projections template are based on values at the year end. If there are significant changes in the balance sheet items during the financial period, it is best to average the assets over the period using the beginning and ending balances.

It is important to monitor the two return ratios produced by the template in order to ensure that they are in line with industry norms. Any variation in either the absolute value or the trend in the ratio should be analysed and explained before finalizing the business plan financial projections. Generally, the higher the return ratio the better the profit performance of the business but the higher the risks involved.

Financial Projection Return Ratios October 5th, 2016Team

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