The financial projections template includes two important return ratios.
- Return on assets (Operating income / Assets)
- Return on equity (Net income / Equity)
Operating Return on Assets (ROA)
The operating return on assets ratio indicates the amount of operating income 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 operating return on assets is the same as the return on the liabilities and equity funding used within the business.
The operating return on assets formula is as follows:
Operating return on assets = Operating income / Assets
Real Life Operating 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.
|Operating return on assets||23.67%||1.86%|
Further information on the calculation of the ratio can be found at our operating return on assets tutorial.
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.
|Profit margin ratio||21.67%||0.37%|
|Asset turnover ratio||0.826||1.854|
|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.
Further information on the calculation of the ratio can be found at our return on equity tutorial.
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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.