ShmoopTube

Where Monty Python meets your 10th grade teacher.

Search Thousands of Shmoop Videos

Principles of Finance: Unit 4, ROE Is Not a Type of Sushi 4 Views


Share It!


Description:

ROE v ROA: The Smackdown. ROE is Return on Equity; ROA is Return on Assets. There's also ROB - Return of Late Library Books.

Language:
English Language

Transcript

00:00

principles of finance a la shmoop ROE. it's not a type of sushi. when

00:08

financial managers think about the word returns ,they're not thinking about you [ man in suit smiles]

00:12

know that blouse washed me out so I'm taking it back to Macy's for a different

00:16

color. rather they're thinking about financial returns of the flavor oh we

00:21

put a dollar in today and we expect a lot more than a dollar back in a few

00:25

years. that's financial return and there are really two primary measures managers

00:30

rely on return on assets ROA or return on equity, ROE. all right well the

00:36

broader concept just asks am i investing well? well ROA measures the financial

00:42

return investors received over the course of a year, generally. and is

00:46

calculated as return divided by total assets. so what kind of return goes in

00:51

the numerator here? well it could be net income you know the only problem here is

00:56

that net income sometimes has one-time charges ie a lawsuit that was settled

01:01

and you know we lost, or it could have big losses this year which won't happen

01:05

again next year, so we backed them out. well maybe we call this recurring

01:10

returns so we can subtract out the one-timers. yeah that works all right [equation for recurring returns]

01:13

well what about taxes and interest costs in a volatile interest rate world? what

01:18

do we do about those and what about one-time gains on a sale of a subsidiary

01:21

which carried a lot of debt and tax losses with it? translation? yeah it's all

01:25

very complicated. well most managers get past all that

01:28

noise by ignoring net income and instead reporting operating earnings. so check

01:34

this out our revenues cups liquid rent labor and five six to five yeah there we

01:39

go. in this little model it's the $7,500

01:42

figure, and we scan our balance sheet for you here at no extra charge from

01:47

Schmucks current and cents and pounds of sugar. all right so we have one hundred

01:51

eighteen thousand bucks in total assets. very interesting and that these are the

01:56

numbers three days before the Super Bowl transaction and they're not pretty, right?

02:00

from one hundred eighteen thousand dollars in total assets we've only been [balance sheet pictured]

02:04

able to take out seventy five hundred bucks in operating profits. you could

02:09

have invested that money in a lot of places and done way better than the six

02:12

percent returns that it implies, but if you wait

02:15

a few days and the transaction happens, depending on the deal structure well all

02:20

the sudden you have something more like fifty thousand dollars in operating

02:23

profits with about the same total assets so all of a sudden your ratios look a

02:28

whole lot better. moral of the story, sales matter. having tons of accounts

02:33

receivable are nice but they aren't sales. sales convert inventory to cash,

02:38

and that generally speaking is a good thing. so if you had operating profits of

02:42

fifty thousand dollars in total assets of a hundred thousand then your ROA

02:46

would be 50%. think about it in the form that if you had invested $100,000 this [equation]

02:53

year to just buy those assets and you already got half your money back, well

02:57

you'd be doing exceedingly well. big number. you're swinging. ROE is a

03:02

different measure of how well managers are doing in returning earnings to

03:07

shareholders. ROE uses fully taxed earnings or net income after everything

03:13

dead included and it puts it in the numerator.

03:16

why use fully taxed and include interest costs well because in this case ROA is

03:21

quote wedded unquote to the common equity of the firm or rather the equity

03:26

value of the firm. a big part of the equity value as far as earnings goes [ROE and equity value get married]

03:30

includes basically everything. well as the common owner you are the backstop

03:35

the last word the final say so you have to pay for everything. so everything

03:39

should be included in this calculation. hopefully not surprising then the common

03:43

equity or shareholders common stock equity is the denominator. and our little

03:49

balance sheet above that would be the ninety eight thousand dollar figure

03:52

right there - if our net income was nine thousand eight hundred in a given year

03:56

then applying Fancy Pants math we'd have ROES ten percent right ?and oh by the

04:01

way in any of these calculations where you take a year's income in whatever

04:05

form operating net income da da da you know you put it over the

04:09

beginning of the year balance sheet item. why? because at the beginning of the year [equation]

04:13

you have your finite universe of assets with which to manage. based on those

04:18

resources you then generate returns for the subsequent following year. so the

04:24

denominator is kind of easy. shareholders common

04:27

stock equity at the beginning of the year, that's it so next time you hear about

04:30

ROE, don't think about that sushi think about the Benjamins you pay to eat

04:34

it. [man grimaces at restaurant bill]

Up Next

GED Social Studies 1.1 Civics and Government
39794 Views

GED Social Studies 1.1 Civics and Government

Related Videos

Fake News
11938 Views

How do you tell fake news from real news?

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: How Are Risks and Rewards Related?
589 Views

How are risk and reward related? Take more risk, expect more reward. A lottery ticket might be worth a billion dollars, but if the odds are one in...