ba financial ratios

5/24/2018 BA Financial Ratios

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Business AdministrationFinancial Ratios


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Contents

Articles

Financial ratio 1

Gross margin 9

Operating margin 11

Profit margin 12

Return on equity 13

Rate of return 15

Return on assets 25

Return on assets Du Pont 26

Return on net assets 28

Return on capital 28

Risk adjusted return on capital 29

Cash flow return on investment 30

Current ratio 30

Cash ratio 31

Operating cash flow 37

Net present value 38

Internal rate of return 43

References

Article Sources and Contributors 49

Image Sources, Licenses and Contributors 51

Article Licenses

License 52


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Financial ratio 1

Financial ratio

Accountancy

Key concepts

AccountantBookkeepingCash and accrual basisConstant Item Purchasing Power AccountingCost of goods soldDebits and

creditsDouble-entry systemFair value accountingFIFO & LIFOGAAP / International Financial Reporting StandardsGeneral

ledgerHistorical costMatching principleRevenue recognitionTrial balance

Fields of accounting

CostFinancialForensicFundManagementTax

Financial statements

Statement of Financial PositionStatement of cash flowsStatement of changes in equityStatement of comprehensive income

NotesMD&A

Auditing

Auditor's reportFinancial auditGAAS / ISAInternal auditSarbanesOxley Act

Accounting qualifications

CACGACMA CPA

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an

enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the

overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a

firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Security analysts use

financial ratios to compare the strengths and weaknesses in various companies.[1]

If shares in a company are traded

in a financial market, the market price of the shares is used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%.

Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as

earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1,

such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was

above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be

more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot

be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Sources of data for financial ratios

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash

flows or (sometimes) the statement of retained earnings. These comprise the firm's "accounting statements" or

financial statements. The statements' data is based on the accounting method and accounting standards used by the

organization.

Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis.

Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity

ratios measure the availability of cash to pay debt.[2]

Activity ratios measure how quickly a firm converts non-cash

assets to cash assets.

[3]

Debt ratios measure the firm's ability to repay long-term debt.

[4]

Profitability ratiosmeasure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.

[5]Market

ratios measure investor response to owning a company's stock and also the cost of issuing stock.[6]
http://en.wikipedia.org/w/index.php?title=Financial_statementshttp://en.wikipedia.org/w/index.php?title=Statement_of_retained_earningshttp://en.wikipedia.org/w/index.php?title=Statement_of_cash_flowshttp://en.wikipedia.org/w/index.php?title=Statement_of_cash_flowshttp://en.wikipedia.org/w/index.php?title=Income_statementhttp://en.wikipedia.org/w/index.php?title=Balance_sheethttp://en.wikipedia.org/w/index.php?title=P/E_ratiohttp://en.wikipedia.org/w/index.php?title=Reciprocal_%28mathematics%29http://en.wikipedia.org/w/index.php?title=P/E_ratiohttp://en.wikipedia.org/w/index.php?title=Earnings_yieldhttp://en.wikipedia.org/w/index.php?title=Percenthttp://en.wikipedia.org/w/index.php?title=Decimal_separatorhttp://en.wikipedia.org/w/index.php?title=Financial_markethttp://en.wikipedia.org/w/index.php?title=Financial_analysthttp://en.wikipedia.org/w/index.php?title=Creditorhttp://en.wikipedia.org/w/index.php?title=Shareholderhttp://en.wikipedia.org/w/index.php?title=Accountinghttp://en.wikipedia.org/w/index.php?title=Financial_statementhttp://en.wikipedia.org/w/index.php?title=Certified_Public_Accountanthttp://en.wikipedia.org/w/index.php?title=Certified_Management_Accountanthttp://en.wikipedia.org/w/index.php?title=Certified_General_Accountanthttp://en.wikipedia.org/w/index.php?title=Chartered_Accountanthttp://en.wikipedia.org/w/index.php?title=Sarbanes%E2%80%93Oxley_Acthttp://en.wikipedia.org/w/index.php?title=Internal_audithttp://en.wikipedia.org/w/index.php?title=International_Standards_on_Auditinghttp://en.wikipedia.org/w/index.php?title=Generally_Accepted_Auditing_Standardshttp://en.wikipedia.org/w/index.php?title=Financial_audithttp://en.wikipedia.org/w/index.php?title=Auditor%27s_reporthttp://en.wikipedia.org/w/index.php?title=Audithttp://en.wikipedia.org/w/index.php?title=MD%26Ahttp://en.wikipedia.org/w/index.php?title=Notes_to_the_Financial_Statementshttp://en.wikipedia.org/w/index.php?title=Statement_of_comprehensive_incomehttp://en.wikipedia.org/w/index.php?title=Statement_of_changes_in_equityhttp://en.wikipedia.org/w/index.php?title=Cash_flow_statementhttp://en.wikipedia.org/w/index.php?title=Statement_of_Financial_Positionhttp://en.wikipedia.org/w/index.php?title=Financial_statementhttp://en.wikipedia.org/w/index.php?title=Tax_accounting_in_the_United_Stateshttp://en.wikipedia.org/w/index.php?title=Management_accountinghttp://en.wikipedia.org/w/index.php?title=Fund_accountinghttp://en.wikipedia.org/w/index.php?title=Forensic_accountinghttp://en.wikipedia.org/w/index.php?title=Financial_accountancyhttp://en.wikipedia.org/w/index.php?title=Cost_accountinghttp://en.wikipedia.org/w/index.php?title=Trial_balancehttp://en.wikipedia.org/w/index.php?title=Revenue_recognitionhttp://en.wikipedia.org/w/index.php?title=Matching_principlehttp://en.wikipedia.org/w/index.php?title=Historical_costhttp://en.wikipedia.org/w/index.php?title=General_ledgerhttp://en.wikipedia.org/w/index.php?title=General_ledgerhttp://en.wikipedia.org/w/index.php?title=International_Financial_Reporting_Standardshttp://en.wikipedia.org/w/index.php?title=Generally_Accepted_Accounting_Principleshttp://en.wikipedia.org/w/index.php?title=FIFO_and_LIFO_accountinghttp://en.wikipedia.org/w/index.php?title=Mark-to-market_accountinghttp://en.wikipedia.org/w/index.php?title=Double-entry_bookkeeping_systemhttp://en.wikipedia.org/w/index.php?title=Debits_and_creditshttp://en.wikipedia.org/w/index.php?title=Debits_and_creditshttp://en.wikipedia.org/w/index.php?title=Cost_of_goods_soldhttp://en.wikipedia.org/w/index.php?title=Constant_Purchasing_Power_Accountinghttp://en.wikipedia.org/w/index.php?title=Comparison_of_Cash_Method_and_Accrual_Method_of_accountinghttp://en.wikipedia.org/w/index.php?title=Bookkeepinghttp://en.wikipedia.org/w/index.php?title=Accountanthttp://en.wikipedia.org/w/index.php?title=Accountancy


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Financial ratio 2

Financial ratios allow for comparisons

between companies

between industries

between different time periods for one company

between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something else, like past performance oranother company. Thus, the ratios of firms in different industries, which face different risks, capital requirements,

and competition are usually hard to compare.

Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow

various standard accounting practices. Most public companies are required by law to use generally accepted

accounting principles for their home countries, but private companies, partnerships and sole proprietorships may not

use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards

to produce their financial statements, or they may use the generally accepted accounting principles of their homecountry.

There is no international standard for calculating the summary data presented in all financial statements, and the

terminology is not always consistent between companies, industries, countries and time periods.

Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the

Internet. Sales reported by a firm are usually net sales, which deduct returns, allowances, and early payment

discounts from the charge on an invoice. Net income is always the amount after taxes, depreciation, amortization,

and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below).

Companies that are primarily involved in providing services with labour do not generally report "Sales" based on

hours. These companies tend to report "revenue" based on the monetary value of income that the services provide.

Note that Shareholder's Equity and Owner's Equity are not the same thing, Shareholder's Equity represents the total

number of shares in the company multiplied by each share's book value; Owner's Equity represents the total number

of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share's

book value. It is important to make this distinction when calculating ratios.

Other abbreviations

(Note: These are not ratios, but values in currency.)

COGS = Cost of goods sold, or cost of sales.

EBIT = Earnings before interest and taxes

EBITDA = Earnings before interest, taxes, depreciation, and amortization

EPS = Earnings per share
http://en.wikipedia.org/w/index.php?title=Earnings_per_sharehttp://en.wikipedia.org/w/index.php?title=Amortizationhttp://en.wikipedia.org/w/index.php?title=Depreciationhttp://en.wikipedia.org/w/index.php?title=EBITDAhttp://en.wikipedia.org/w/index.php?title=Taxeshttp://en.wikipedia.org/w/index.php?title=Interesthttp://en.wikipedia.org/w/index.php?title=Net_incomehttp://en.wikipedia.org/w/index.php?title=EBIThttp://en.wikipedia.org/w/index.php?title=Cost_of_goods_soldhttp://en.wikipedia.org/w/index.php?title=Controlling_interesthttp://en.wikipedia.org/w/index.php?title=Net_incomehttp://en.wikipedia.org/w/index.php?title=Invoicehttp://en.wikipedia.org/w/index.php?title=Net_saleshttp://en.wikipedia.org/w/index.php?title=Sales_%28accounting%29http://en.wikipedia.org/w/index.php?title=Internethttp://en.wikipedia.org/w/index.php?title=International_Financial_Reporting_Standardshttp://en.wikipedia.org/w/index.php?title=Sole_proprietorshiphttp://en.wikipedia.org/w/index.php?title=Partnershiphttp://en.wikipedia.org/w/index.php?title=Private_companyhttp://en.wikipedia.org/w/index.php?title=Generally_accepted_accounting_principleshttp://en.wikipedia.org/w/index.php?title=Generally_accepted_accounting_principleshttp://en.wikipedia.org/w/index.php?title=Public_companyhttp://en.wikipedia.org/w/index.php?title=Standard_accounting_practicehttp://en.wikipedia.org/w/index.php?title=Accounting_methodshttp://en.wikipedia.org/w/index.php?title=Benchmarking


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Financial ratio 3

Ratios

Profitability ratios

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate

of return

Gross margin, Gross profit margin or Gross Profit Rate[7][8]

OR

Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)[8]

[9]

Note: Operating income is the difference between operating revenues and operating expenses, but it is alsosometimes used as a synonym for EBIT and operating profit.

[10]This is true if the firm has no non-operating

income. (Earnings before interest and taxes / Sales[11]

[12]

)

Profit margin, net margin or net profit margin[13]

Return on equity (ROE)[13]

Return on investment (ROI ratio or Du Pont Ratio)[6]

Return on assets (ROA)[14]

Return on assets Du Pont (ROA Du Pont)[15]

Return on Equity Du Pont (ROE Du Pont)

Return on net assets (RONA)

Return on capital (ROC)

Risk adjusted return on capital (RAROC)
http://en.wikipedia.org/w/index.php?title=Return_on_Equity_Du_Ponthttp://en.wikipedia.org/w/index.php?title=Du_Pont_Ratiohttp://en.wikipedia.org/w/index.php?title=Return_on_investmenthttp://en.wikipedia.org/w/index.php?title=Earnings_before_interest_and_taxes


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Financial ratio 4

OR

Return on capital employed (ROCE)

Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity

Cash flow return on investment (CFROI)

Efficiency ratio

Net gearing

Basic Earnings Power Ratio[16]

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio (Working Capital Ratio)[17]

Acid-test ratio (Quick ratio)[17]

Cash ratio[17]

Operation cash flow ratio
http://en.wikipedia.org/w/index.php?title=Quick_ratiohttp://en.wikipedia.org/w/index.php?title=Accounting_liquidityhttp://en.wikipedia.org/w/index.php?title=Basic_Earnings_Power_Ratiohttp://en.wikipedia.org/w/index.php?title=Net_gearinghttp://en.wikipedia.org/w/index.php?title=Efficiency_ratiohttp://en.wikipedia.org/w/index.php?title=Return_on_capital_employed


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Financial ratio 5

Activity ratios (Efficiency Ratios)

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period[3]

Degree of Operating Leverage (DOL)

DSO Ratio.[18]

Average payment period[3]

Asset turnover[19]

Stock turnover ratio[20]

[21]

Receivables Turnover Ratio[22]

Inventory conversion ratio[4]

Inventory conversion period (essentially same thing as above)

Receivables conversion period

Payables conversion period

Cash Conversion Cycle
http://en.wikipedia.org/w/index.php?title=Cash_conversion_cyclehttp://en.wikipedia.org/w/index.php?title=Inventory_conversionhttp://en.wikipedia.org/w/index.php?title=Receivables_Turnover_Ratiohttp://en.wikipedia.org/w/index.php?title=Stock_turnoverhttp://en.wikipedia.org/w/index.php?title=Asset_turnoverhttp://en.wikipedia.org/w/index.php?title=Average_payment_periodhttp://en.wikipedia.org/w/index.php?title=DSO_Ratiohttp://en.wikipedia.org/w/index.php?title=Degree_of_Operating_Leveragehttp://en.wikipedia.org/w/index.php?title=Debtor_collection_period


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Financial ratio 6

Debt ratios (leveraging ratios)

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage.

Debt ratio[23]

Debt to equity ratio[24]

Long-term Debt to equity (LT Debt to Equity)[24]

Times interest-earned ratio / Interest Coverage Ratio[24]

OR

Debt service coverage ratio

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

Earnings per share (EPS)[25]

Payout ratio[25]

[26]

OR

Dividend cover (the inverse of Payout Ratio)

P/E ratio

Dividend yield

Cash flow ratio or Price/cash flow ratio[27]
http://en.wikipedia.org/w/index.php?title=Price/cash_flow_ratiohttp://en.wikipedia.org/w/index.php?title=Dividend_yieldhttp://en.wikipedia.org/w/index.php?title=PE_ratiohttp://en.wikipedia.org/w/index.php?title=Dividend_coverhttp://en.wikipedia.org/w/index.php?title=Payout_ratiohttp://en.wikipedia.org/w/index.php?title=Earnings_per_sharehttp://en.wikipedia.org/w/index.php?title=Debt_service_coverage_ratiohttp://en.wikipedia.org/w/index.php?title=Times_interest-earned_ratio_/_Interest_Coverage_Ratiohttp://en.wikipedia.org/w/index.php?title=Long-term_Debt_to_equityhttp://en.wikipedia.org/w/index.php?title=Debt_to_equity_ratiohttp://en.wikipedia.org/w/index.php?title=Debt_ratiohttp://en.wikipedia.org/w/index.php?title=Leverage_%28finance%29


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Financial ratio 7

Price to book value ratio (P/B or PBV)[27]

Price/sales ratio

PEG ratio

Other Market Ratios

EV/EBITDA

EV/Sales

Cost/Income ratio

Sector-specific ratios

EV/capacity

EV/output

Capital Budgeting RatiosIn addition to assisting management and owners in diagnosing the financial health of their company, ratios can also

help managers make decisions about investments or projects that the company is considering to take, such as

acquisitions, or expansion.

Many formal methods are used in capital budgeting, including the techniques such as

Net present value

Profitability index

Internal rate of return

Modified Internal Rate of Return

Equivalent annuity
http://en.wikipedia.org/w/index.php?title=Equivalent_Annual_Costhttp://en.wikipedia.org/w/index.php?title=Modified_Internal_Rate_of_Returnhttp://en.wikipedia.org/w/index.php?title=Profitability_indexhttp://en.wikipedia.org/w/index.php?title=EV/outputhttp://en.wikipedia.org/w/index.php?title=EV/capacityhttp://en.wikipedia.org/w/index.php?title=Cost/Income_ratiohttp://en.wikipedia.org/w/index.php?title=EV/Saleshttp://en.wikipedia.org/w/index.php?title=EV/EBITDAhttp://en.wikipedia.org/w/index.php?title=PEG_ratiohttp://en.wikipedia.org/w/index.php?title=Price/sales_ratiohttp://en.wikipedia.org/w/index.php?title=P/B_ratio


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Financial ratio 8

References

[1] Groppelli, Angelico A.; Ehsan Nikbakht (2000).Finance, 4th ed. Barron's Educational Series, Inc.. pp. 433. ISBN 0764112759.

[2] Groppelli, p. 434.




[6] Groppelli, p. 445.[7] Williams, P. 265.

[8] Williams, p. 1094.

[9] Williams, Jan R.; Susan F. Haka, Mark S. Bettner, Joseph V. Carcello (2008).Financial & Managerial Accounting. McGraw-Hill Irwin.

pp. 266. ISBN 9780072996500.

[10] http://www.investorwords.com/3460/operating_income.html Operating income definition


[12] Bodie, Zane; Alex Kane and Alan J. Marcus (2004).Essentials of Investments, 5th ed. McGraw-Hill Irwin. pp. 459. ISBN 0072510773.


[14] Professor Cram. "Ratios of Profitability: Return on Assets" College-Cram.com. 14 May 2008

(http://www.college-cram.com/study/finance/

ratios-of-profitability/return-on-assets/)

[15] Professor Cram. "Ratios of Profitability: Return on Assets Du Pont" College-Cram.com. 14 May 2008 (http://www.college-cram.com/study/

finance/ratios-of-profitability/return-on-assets-du-pont/)

[16] Weston, J. (1990).Essentials of Managerial Finance. Hinsdale: Dryden Press. p. 295. ISBN 0030307333.


[18] Houston, Joel F.; Brigham, Eugene F. (2009).Fundamentals of Financial Management. [Cincinnati, Ohio]: South-Western College Pub.

p. 90. ISBN 0-324-59771-1.

[19] Bodie, p. 459.


[21] Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996).Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore:

John Wiley & Sons, Inc. p. 801-802.

[22] Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996).Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore:

John Wiley & Sons, Inc. p. 800.

[23] Groppelli, p. 440; Williams, p. 640.





External links

Stock Valuation Metrics (http://www.retailinvestor.org/valuemetrics.html)

A Review of Financial Ratio Analysis (http://lipas.uwasa.fi/~ts/ejre/ejre.html)

On the Classification of Financial Ratios (http://lipas.uwasa.fi/~ts/sera/sera.html)
http://lipas.uwasa.fi/~ts/sera/sera.htmlhttp://lipas.uwasa.fi/~ts/ejre/ejre.htmlhttp://www.retailinvestor.org/valuemetrics.htmlhttp://www.college-cram.com/study/finance/ratios-of-profitability/return-on-assets-du-pont/http://www.college-cram.com/study/finance/ratios-of-profitability/return-on-assets-du-pont/http://www.college-cram.com/study/finance/ratios-of-profitability/return-on-assets/http://www.college-cram.com/study/finance/ratios-of-profitability/return-on-assets/http://www.investorwords.com/3460/operating_income.html


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Gross margin 9

Gross margin

Gross margin, gross profit margin or gross profit rate is the difference between the sales and the production costs

excluding overhead, payroll, taxation, and interest payments. Gross margin can be defined as the amount of

contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover

overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross

profit and sales revenue. It is a measure of how well each dollar of a company's revenue is utilized to cover the costs

of goods sold.[1]

It can be expressed in absolute terms:

Gross margin = net sales - cost of goods sold + annual sales return

or as the ratio of gross profit to sales revenue, usually in the form of a percentage:

Cost of sales (also known as cost of goods (CoGs)) includes variable costs and fixed costs directly linked to the sale,

such as material costs, labor, supplier profit, shipping costs, etc. It does not include indirect fixed costs like office

expenses, rent, administrative costs, etc.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer

it will be their markup over wholesale. Larger gross margins are generally good for companies, with the exception of

discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny

margins.

How gross margin is used in sales

Retailers can measure their profit by using two basic methods, markup and margin, both of which give a description

of the gross profit of the sale. The markup expresses profit as a percentage of the retailer's cost for the product. The

margin expresses profit as a percentage of the retailer's sales price for the product. These two methods give different

percentages as results, but both percentages are valid descriptions of the retailer's profit. It is important to specify

which method you are using when you refer to a retailer's profit as a percentage.

Some retailers use margins because you can easily calculate profits from a sales total. If your margin is 30%, then

30% of your sales total is profit. If your markup is 30%, the percentage of your daily sales that are profit will not be

the same percentage.

Some retailers use markups because it is easier to calculate a sales price from a cost using markups. If your markup

is 40%, then your sales price will be 40% above the item cost. If your margin is 40%, your sales price will not be

equal to 40% over cost (indeed it will be 60% above the item cost).

Markup

Markup can be expressed either as a decimal or as a percentage, but is used as a multiplier. Here is an example:

If a product costs the company $100 to make and they wish to make a 50% profit on the sale of the product (sale

dollars) they would have to use a markup of 100%. To calculate the price to the customer, you simply take the

product cost of $100 and multiply it by (1 + the markup), e.g.: 1+1=2, arriving at the selling price of $200.

The equation for calculating gross margin is: gross margin = sales - cost of goods sold

A simple way to keep markup and gross margin factors straight is to remember that:

1. Percent of markup is 100 times the price difference divided by the cost.

2. Percent of gross margin is 100 times the price difference divided by the selling price.
http://en.wikipedia.org/w/index.php?title=Markup_%28business%29http://en.wikipedia.org/w/index.php?title=Retailhttp://en.wikipedia.org/w/index.php?title=Revenuehttp://en.wikipedia.org/w/index.php?title=Gross_profithttp://en.wikipedia.org/w/index.php?title=Gross_profithttp://en.wikipedia.org/w/index.php?title=Interesthttp://en.wikipedia.org/w/index.php?title=Taxationhttp://en.wikipedia.org/w/index.php?title=Payrollhttp://en.wikipedia.org/w/index.php?title=Overhead_%28business%29


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Gross margin 10

Gross margin (as a percentage of sales)

Most people find it easier to work with gross margin because it directly tells you how many of the sale dollars are

profit. In reference to the two examples above:

The $200 price that includes a 100% markup represents a 50% gross margin. Gross margin is just the percentage of

the selling price that is profit. In this case 50% of the price is profit, or $100.

In the more complex example of selling price $339, a markup of 66% represents approximately a 40% gross margin.

This means that 40% of the $339 is profit. Again, gross margin is just the direct percentage of profit in the sale price.

In accounting, the gross margin refers to sales minus cost of goods sold. It is not necessarily profit as other expenses

such as sales, administrative, and financial must be deducted.And it means company are reducing their cost of

production or passing their cost to customers. the higher ratio is better

Converting between gross margin and markup

The formula to convert a markup to gross margin is:

Examples:

Markup = 100%; GM = [1 / (1 + 1)] = 0.5 = 50%

Markup = 66%; GM = [0.66 / (1 + 0.66)] = 0.39759036 = 39.759036%

The formula to convert a gross margin to markup is:

Examples:

Gross margin = 0.5 = 50%; markup = [0.5 / (1 - 0.5)] = 1 = 100%

Gross margin = 0.39759036 = 39.759036%; markup = [0.39759036 / (1 - 0.39759036)] = 0.659999996 = 66%

Using gross margin to calculate selling price

Given the cost of an item, one can compute the selling price required to achieve a specific gross margin. For

example, if your product costs $100 and the required gross margin is 40%, then

Selling price = $100 / (1 - 40%) = $100 / 0.60 = $166.67

Differences between industries

In some industries, like clothing for example, profit margins are expected to be near the 40% mark, as the goods

need to be bought from suppliers at a certain rate before they are resold. In other industries such as software product

development, since the cost of duplication is negligible, the gross profit margin can be higher than 80% in many

cases.


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Gross margin 11

References

[1] Berman, Karen (2006).Financial Intelligence. Boston: Harvard Business School Press. p. 152. ISBN 1591397642.

Operating margin

In business, operating margin, operating income margin, operating profit margin or return on sales (ROS) is

the ratio of operating income (operating profit in the UK) divided by net sales, usually presented in percent.

Example

The Coca Cola Company

Consolidated Statements of Income[1]

(In millions)

Net Operating Revenues $ 20,088

Gross Profit $ 15,924

Operating Income $ 6,318

Income Before Income Taxes $ 6,578

Net Income $ 5,080

(Relevant figures in italics)

It is a measurement of what proportion of a company's revenue is left over, before taxes and other indirect costs

(such as rent, bonus, interest, etc.), after paying for variable costs of production as wages, raw materials, etc. A good

operating margin is needed for a company to be able to pay for its fixed costs, such as interest on debt. A higher

operating margin means that the company has less financial risk.

http://www.moneychimp.com/articles/financials/income.htm

Operating margin can be considered total revenue from product sales less all costs before adjustment for taxes,

dividends to shareholders, and interest on debt

References

[1] The Coca Cola Company Form 10-K SEC Filing 2006, p 67
http://www.moneychimp.com/articles/financials/income.htmhttp://en.wikipedia.org/w/index.php?title=Net_Incomehttp://en.wikipedia.org/w/index.php?title=Operating_Incomehttp://en.wikipedia.org/w/index.php?title=Gross_Profithttp://en.wikipedia.org/w/index.php?title=Revenuehttp://en.wikipedia.org/w/index.php?title=United_Kingdomhttp://en.wikipedia.org/w/index.php?title=Operating_incomehttp://en.wikipedia.org/w/index.php?title=Business


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Profit margin 12

Profit margin

Profit margin, net margin, net profit margin or net profit ratio all refer to a measure of profitability. It is

calculated by finding the net profit as a percentage of the revenue.[1]

The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for

different entities. Individual businesses' operating and financing arrangements vary so much that different entities are

bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low

profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net

loss, or a negative margin.

Profit margin is an indicator of a company's pricing strategies and how well it controls costs. Differences in

competitive strategy and product mix cause the profit margin to vary among different companies.[2]

ConfusionProfit margin is frequently confused with markup. It's not uncommon for entrepreneurs to erroneously claim profit

margins over 100%. Most likely these entrepreneurs are referring to the markup on a product as a percentage of

product cost.

References

[1] "profit margin Definition" (http://www.investorwords.com/3885/profit_margin.html).InvestorWords. InvestorGuide.com. . Retrieved

December 17, 2009.

[2] "profit margin" (http://financial-dictionary.thefreedictionary.com/profit+margin). The Free Dictionary. Farlex. . Retrieved December 17,

2009.
http://en.wikipedia.org/w/index.php?title=Farlexhttp://en.wikipedia.org/w/index.php?title=The_Free_Dictionaryhttp://financial-dictionary.thefreedictionary.com/profit+marginhttp://en.wikipedia.org/w/index.php?title=InvestorGuide.comhttp://en.wikipedia.org/w/index.php?title=InvestorWordshttp://www.investorwords.com/3885/profit_margin.htmlhttp://en.wikipedia.org/w/index.php?title=Markup_%28business%29http://en.wikipedia.org/w/index.php?title=Revenuehttp://en.wikipedia.org/w/index.php?title=Net_profithttp://en.wikipedia.org/w/index.php?title=Profit_%28accounting%29


15/54

Return on equity 13

Return on equity

Accountancy

Key concepts

AccountantBookkeepingCash and accrual basisConstant Item Purchasing Power AccountingCost of goods soldDebits and

creditsDouble-entry systemFair value accountingFIFO & LIFOGAAP / International Financial Reporting StandardsGeneral

ledgerHistorical costMatching principleRevenue recognitionTrial balance

Fields of accounting

CostFinancialForensicFundManagementTax

Financial statements

Statement of Financial PositionStatement of cash flowsStatement of changes in equityStatement of comprehensive income

NotesMD&A

Auditing

Auditor's reportFinancial auditGAAS / ISAInternal auditSarbanesOxley Act

Accounting qualifications

CACGACMA CPA

Return on equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common

stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also

known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate

earnings growth. ROEs between 15% and 20% are considered desirable.[1]

The formula

[2]

ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends)

divided by total equity (excluding preferred shares), expressed as a percentage. As with many financial ratios, ROE

is best used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS),

you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company.

The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company

a high growth rate. The benefit can also come as a dividend on common shares or as a combination of dividends and

reinvestment in the company. ROE is presumably irrelevant if the earnings are not reinvested.

The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend

payout is 20%, the growth expected will be only 80% of the ROE rate.

The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of

book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).

New investments may not be as profitable as the existing business. Ask "what is the company doing with its

earnings?"

Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much

financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share'

basis, i.e., earnings per share/book value per share.
http://en.wikipedia.org/w/index.php?title=Earnings_per_sharehttp://en.wikipedia.org/w/index.php?title=Net_incomehttp://en.wikipedia.org/w/index.php?title=Fiscal_yearhttp://en.wikipedia.org/w/index.php?title=Shareholders%27_equityhttp://en.wikipedia.org/w/index.php?title=Certified_Public_Accountanthttp://en.wikipedia.org/w/index.php?title=Certified_Management_Accountanthttp://en.wikipedia.org/w/index.php?title=Certified_General_Accountanthttp://en.wikipedia.org/w/index.php?title=Chartered_Accountanthttp://en.wikipedia.org/w/index.php?title=Sarbanes%E2%80%93Oxley_Acthttp://en.wikipedia.org/w/index.php?title=Internal_audithttp://en.wikipedia.org/w/index.php?title=International_Standards_on_Auditinghttp://en.wikipedia.org/w/index.php?title=Generally_Accepted_Auditing_Standardshttp://en.wikipedia.org/w/index.php?title=Financial_audithttp://en.wikipedia.org/w/index.php?title=Auditor%27s_reporthttp://en.wikipedia.org/w/index.php?title=Audithttp://en.wikipedia.org/w/index.php?title=MD%26Ahttp://en.wikipedia.org/w/index.php?title=Notes_to_the_Financial_Statementshttp://en.wikipedia.org/w/index.php?title=Statement_of_comprehensive_incomehttp://en.wikipedia.org/w/index.php?title=Statement_of_changes_in_equityhttp://en.wikipedia.org/w/index.php?title=Cash_flow_statementhttp://en.wikipedia.org/w/index.php?title=Statement_of_Financial_Positionhttp://en.wikipedia.org/w/index.php?title=Financial_statementhttp://en.wikipedia.org/w/index.php?title=Tax_accounting_in_the_United_Stateshttp://en.wikipedia.org/w/index.php?title=Management_accountinghttp://en.wikipedia.org/w/index.php?title=Fund_accountinghttp://en.wikipedia.org/w/index.php?title=Forensic_accountinghttp://en.wikipedia.org/w/index.php?title=Financial_accountancyhttp://en.wikipedia.org/w/index.php?title=Cost_accountinghttp://en.wikipedia.org/w/index.php?title=Trial_balancehttp://en.wikipedia.org/w/index.php?title=Revenue_recognitionhttp://en.wikipedia.org/w/index.php?title=Matching_principlehttp://en.wikipedia.org/w/index.php?title=Historical_costhttp://en.wikipedia.org/w/index.php?title=General_ledgerhttp://en.wikipedia.org/w/index.php?title=General_ledgerhttp://en.wikipedia.org/w/index.php?title=International_Financial_Reporting_Standardshttp://en.wikipedia.org/w/index.php?title=Generally_Accepted_Accounting_Principleshttp://en.wikipedia.org/w/index.php?title=FIFO_and_LIFO_accountinghttp://en.wikipedia.org/w/index.php?title=Mark-to-market_accountinghttp://en.wikipedia.org/w/index.php?title=Double-entry_bookkeeping_systemhttp://en.wikipedia.org/w/index.php?title=Debits_and_creditshttp://en.wikipedia.org/w/index.php?title=Debits_and_creditshttp://en.wikipedia.org/w/index.php?title=Cost_of_goods_soldhttp://en.wikipedia.org/w/index.php?title=Constant_Purchasing_Power_Accountinghttp://en.wikipedia.org/w/index.php?title=Comparison_of_Cash_Method_and_Accrual_Method_of_accountinghttp://en.wikipedia.org/w/index.php?title=Bookkeepinghttp://en.wikipedia.org/w/index.php?title=Accountanthttp://en.wikipedia.org/w/index.php?title=Accountancy


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Return on equity 14

The DuPont formula

The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three

important components. Essentially, ROE will equal the net margin multiplied by asset turnover multiplied by

financial leverage. Splitting return on equity into three parts makes it easier to understand changes in ROE over time.

For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE.

Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting

in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative

to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not.

Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE.[1]

Financial leverage benefits

diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of

debt rises as creditors demand a higher risk premium, and ROE decreases.[3]

Increased debt will make a positive

contribution to a firm's ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the

debt.[4]

Notes

[1] " Profitability Indicator Ratios: Return On Equity (http://www.investopedia.com/university/ratios/profitability-indicator/ratio4.asp)",

Richard LothInvestopedia

[2] http://www.answers.com/topic/return-on-equity Answers.com Return on Equity

[3] Woolridge, J. Randall and Gray, Gary; Applied Principles of Finance (2006)

[4] Bodie, Kane, Markus, "Investments"

External links

Annual Ratio Definitions (http://gold.globeinvestor.com/public/help/flat/help_financials_report_ratios.html)
http://gold.globeinvestor.com/public/help/flat/help_financials_report_ratios.htmlhttp://www.answers.com/topic/return-on-equityhttp://en.wikipedia.org/w/index.php?title=Investopediahttp://www.investopedia.com/university/ratios/profitability-indicator/ratio4.asphttp://en.wikipedia.org/w/index.php?title=Cost_of_debthttp://en.wikipedia.org/w/index.php?title=Cost_of_debthttp://en.wikipedia.org/w/index.php?title=Debthttp://en.wikipedia.org/w/index.php?title=Debthttp://en.wikipedia.org/w/index.php?title=Stockhttp://en.wikipedia.org/w/index.php?title=Debthttp://en.wikipedia.org/w/index.php?title=Financial_leveragehttp://en.wikipedia.org/w/index.php?title=Asset_turnoverhttp://en.wikipedia.org/w/index.php?title=Net_marginhttp://en.wikipedia.org/w/index.php?title=Du_Pont_identity


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Rate of return 15

Rate of return

In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just

return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount

of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net

income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the

investment. ROI is usually expressed as a percentage.

Calculation

The initial value of an investment, , does not always have a clearly defined monetary value, but for purposes of

measuring ROI, the expected value must be clearly stated along with the rationale for this initial value. Similarly, the

final value of an investment, , also does not always have a clearly defined monetary value, but for purposes of

measuring ROI, the final value must be clearly stated along with the rationale for this final value.

The rate of return can be calculated over a single period, or expressed as an average over multiple periods of time.

Single-period

Arithmetic return

The arithmetic return is:

is sometimes referred to as the yield. See also: effective interest rate, effective annual rate (EAR) or annual

percentage yield (APY).

Logarithmic or continuously compounded return

The logarithmic return or continuously compounded return, also known as force of interest, is defined as:

It is the reciprocal of the e-folding time.

Multiperiod average returns

Arithmetic average rate of return

The arithmetic average rate of return over n periods is defined as:
http://en.wikipedia.org/w/index.php?title=E-foldinghttp://en.wikipedia.org/w/index.php?title=Compound_interest%23Force_of_interesthttp://en.wikipedia.org/w/index.php?title=Continuous_compoundinghttp://en.wikipedia.org/w/index.php?title=Annual_percentage_yieldhttp://en.wikipedia.org/w/index.php?title=Annual_percentage_yieldhttp://en.wikipedia.org/w/index.php?title=Effective_annual_ratehttp://en.wikipedia.org/w/index.php?title=Effective_interest_ratehttp://en.wikipedia.org/w/index.php?title=Yield_%28finance%29http://en.wikipedia.org/w/index.php?title=Value_%28economics%29http://en.wikipedia.org/w/index.php?title=Cost_basishttp://en.wikipedia.org/w/index.php?title=Debthttp://en.wikipedia.org/w/index.php?title=Capital_%28economics%29http://en.wikipedia.org/w/index.php?title=Assethttp://en.wikipedia.org/w/index.php?title=Net_incomehttp://en.wikipedia.org/w/index.php?title=Net_incomehttp://en.wikipedia.org/w/index.php?title=Profit_%28accounting%29http://en.wikipedia.org/w/index.php?title=Interesthttp://en.wikipedia.org/w/index.php?title=Investmenthttp://en.wikipedia.org/w/index.php?title=Moneyhttp://en.wikipedia.org/w/index.php?title=Finance


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Rate of return 16

Geometric average rate of return

The geometric average rate of return, also known as the True Time-Weighted Rate of Return, over n periods is

defined as:

The geometric average rate of return calculated over n years is also known as the annualized return.

Internal rate of return

The internal rate of return (IRR), also known as the dollar-weighted rate of return, is defined as the value(s) of

that satisfies the following equation:

where:

NPV = net present value of the investment

= cashflow at time

When the cost of capital is smaller than the IRR rate , the investment is profitable, i.e., .

Otherwise, the investment is not profitable.

Comparisons between various rates of return

Arithmetic and logarithmic return

The value of an investment is doubled over a year if the annual ROR = +100%, that is, if = ln(200% /

100%) = ln(2) = 69.3%. The value falls to zero when = -100%, that is, if = -.

Arithmetic and logarithmic returns are not equal, but are approximately equal for small returns. The difference

between them is large only when percent changes are high. For example, an arithmetic return of +50% is equivalent

to a logarithmic return of 40.55%, while an arithmetic return of -50% is equivalent to a logarithmic return of

-69.31%.

Logarithmic returns are often used by academics in their research. The main advantage is that the continuously

compounded return is symmetric, while the arithmetic return is not: positive and negative percent arithmetic returns

are not equal. This means that an investment of $100 that yields an arithmetic return of 50% followed by an

arithmetic return of -50% will result in $75, while an investment of $100 that yields a logarithmic return of 50%

followed by an logarithmic return of -50% it will remain $100.

Comparison of arithmetic and logarithmic returns for initial investment of $100

Initial investment, $100 $100 $100 $100 $100

Final investment, $0 $50 $100 $150 $200

Profit/loss, $100 $50 $0 $50 $100

Arithmetic return, 100% 50% 0% 50% 100%

Logarithmic return, 69.31% 0% 40.55% 69.31%
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Rate of return 17

Arithmetic average and geometric average rates of return

Both arithmetic and geometric average rates of returns are averages of periodic percentage returns. Neither will

accurately translate to the actual dollar amounts gained or lost if percent gains are averaged with percent losses.[1]

A

10% loss on a $100 investment is a $10 loss, and a 10% gain on a $100 investment is a $10 gain. When percentage

returns on investments are calculated, they are calculated for a period of time not based on original investment

dollars, but based on the dollars in the investment at the beginning and end of the period. So if an investment of $100loses 10% in the first period, the investment amount is then $90. If the investment then gains 10% in the next period,

the investment amount is $99.

A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss and gain occurs does not affect the

result. A 50% gain and a 50% loss is a 25% loss. An 80% gain plus an 80% loss is a 64% loss. To recover from a

50% loss, a 100% gain is required. The mathematics of this are beyond the scope of this article, but since investment

returns are often published as "average returns", it is important to note that average returns do not always translate

into dollar returns.

Example #1 Level Rates of Return

Year 1 Year 2 Year 3 Year 4

Rate of Return 5% 5% 5% 5%

Geometric Average at End of Year 5% 5% 5% 5%

Capital at End of Year $105.00 $110.25 $115.76 $121.55

Dollar Profit/(Loss) $5.00 $10.25 $15.76 $21.55

Compound Yield 5% 5.4%

Example #2 Volatile Rates of Return, including losses


Rate of Return 50% -20% 30% -40%

Geometric Average at End of Year 50% 9.5% 16% -1.6%


Dollar Profit/(Loss) ($6.40)

Compound Yield -1.6%

Example #3 Highly Volatile Rates of Return, including losses


Rate of Return -95% 0% 0% 115%

Geometric Average at End of Year -95% -77.6% -63.2% -42.7%


Dollar Profit/(Loss) ($89.25)

Compound Yield -22.3%


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Rate of return 18

Annual returns and annualized returns

Care must be taken not to confuse annual and annualized returns. An annual rate of return is a single-period return,

while an annualized rate of return is a multi-period, geometric average return.

An annual rate of return is the return on an investment over a one-year period, such as January 1 through December

31, or June 3, 2006 through June 2, 2007. Each ROI in the cash flow example above is an annual rate of return.

An annualized rate of return is the return on an investment over a period other than one year (such as a month, or two

years) multiplied or divided to give a comparable one-year return. For instance, a one-month ROI of 1% could be

stated as an annualized rate of return of 12%. Or a two-year ROI of 10% could be stated as an annualized rate of

return of 5%. **For GIPS compliance: you do not annualize portfolios or composites for periods of less than one

year. You start on the 13th month.

In the cash flow example below, the dollar returns for the four years add up to $265. The annualized rate of return for

the four years is: $265 ($1,000 x 4 years) = 6.625%.

Uses

ROI is a measure of cash generated by or lost due to the investment. It measures the cash flow or income stream

from the investment to the investor, relative to the amount invested. Cash flow to the investor can be in the form

of profit, interest, dividends, or capital gain/loss. Capital gain/loss occurs when the market value or resale value of

the investment increases or decreases. Cash flow here does not include the return of invested capital.

Cash Flow Example on $1,000 Investment


Dollar Return $100 $55 $60 $50

ROI 10% 5.5% 6% 5%

ROI values typically used for personal financial decisions include Annual Rate of Return and Annualized Rate

of Return. For nominal risk investments such as savings accounts or Certificates of Deposit, the personal investor

considers the effects of reinvesting/compounding on increasing savings balances over time. For investments in

which capital is at risk, such as stock shares, mutual fund shares and home purchases, the personal investor

considers the effects of price volatility and capital gain/loss on returns.

Profitability ratios typically used by financial analysts to compare a companys profitability over time or

compare profitability between companies include Gross Profit Margin, Operating Profit Margin, ROI ratio,

Dividend yield, Net profit margin, Return on equity, and Return on assets.[2]

During capital budgeting, companies compare the rates of return of different projects to select which projects to

pursue in order to generate maximum return or wealth for the company's stockholders. Companies do so by

considering the average rate of return, payback period, net present value, profitability index, and internal rate of

return for various projects.[3]

A return may be adjusted for taxes to give the after-tax rate of return. This is done in geographical areas or

historical times in which taxes consumed or consume a significant portion of profits or income. The after-tax rate

of return is calculated by multiplying the rate of return by the tax rate, then subtracting that percentage from the

rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25%

0.05 x 0.15 = 0.0075

0.05 - 0.0075 = 0.0425 = 4.25%

A return of 10% taxed at 25% gives an after-tax return of 7.5%
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Rate of return 19

0.10 x 0.25 = 0.025

0.10 - 0.025 = 0.075 = 7.5%

Investors usually seek a higher rate of return on taxable investment returns than on non-taxable investment returns.

A return may be adjusted for inflation to better indicate its true value in purchasing power. Any investment with a

nominal rate of return less than the annual inflation rate represents a loss of value, even though the nominal rate

of return might well be greater than 0%. When ROI is adjusted for inflation, the resulting return is considered an

increase or decrease in purchasing power. If an ROI value is adjusted for inflation, it is stated explicitly, such as

The return, adjusted for inflation, was 2%.

Many online poker tools include ROI in a player's tracked statistics, assisting users in evaluating an opponent's

profitability.

Cash or potential cash returns

Time value of money

Investments generate cash flow to the investor to compensate the investor for the time value of money.

Except for rare periods of significant deflation where the opposite may be true, a dollar in cash is worth less today

than it was yesterday, and worth more today than it will be worth tomorrow. The main factors that are used by

investors to determine the rate of return at which they are willing to invest money include:

estimates of future inflation rates

estimates regarding the risk of the investment (e.g. how likely it is that investors will receive regular

interest/dividend payments and the return of their full capital)

whether or not the investors want the money available (liquid) for other uses.

The time value of money is reflected in the interest rates that banks offer for deposits, and also in the interest rates

that banks charge for loans such as home mortgages. Therisk-free

rate is the rate on U.S. Treasury Bills, because

this is the highest rate available without risking capital.

The rate of return which an investor expects from an investment is called the Discount Rate. Each investment has a

different discount rate, based on the cash flow expected in future from the investment. The higher the risk, the higher

the discount rate (rate of return) the investor will demand from the investment.

Compounding or reinvesting

Compound interest or other reinvestment of cash returns (such as interest and dividends) does not affect the discount

rate of an investment, but it does affect the Annual Percentage Yield, because compounding/reinvestment increases

the capital invested.

For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD) that paid an annual interest rate of 4%,

compounded quarterly, the CD would earn 1% interest per quarter on the account balance. The account balance

includes interest previously credited to the account.
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Rate of return 20

Compound Interest Example

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Capital at the beginning of the period $1,000 $1,010 $1,020.10 $1,030.30

Dollar return for the period $10 $10.10 $10.20 $10.30

Account Balance at end of the period $1,010.00 $1,020.10 $1,030.30 $1,040.60

Quarterly ROI 1% 1% 1% 1%

The concept of 'income stream' may express this more clearly. At the beginning of the year, the investor took $1,000

out of his pocket (or checking account) to invest in a CD at the bank. The money was still his, but it was no longer

available for buying groceries. The investment provided a cash flow of $10.00, $10.10, $10.20 and $10.30. At the

end of the year, the investor got $1,040.60 back from the bank. $1,000 was return of capital.

Once interest is earned by an investor it becomes capital. Compound interest involves reinvestment of capital; the

interest earned during each quarter is reinvested. At the end of the first quarter the investor had capital of $1,010.00,

which then earned $10.10 during the second quarter. The extra dime was interest on his additional $10 investment.

The Annual Percentage Yield or Future value for compound interest is higher than for simple interest because the

interest is reinvested as capital and earns interest. The yield on the above investment was 4.06%.

Bank accounts offer contractually guaranteed returns, so investors cannot lose their capital. Investors/Depositors lend

money to the bank, and the bank is obligated to give investors back their capital plus all earned interest. Because

investors are not risking losing their capital on a bad investment, they earn a quite low rate of return. But their capital

steadily increases.

Returns when capital is at risk

Capital gains and lossesMany investments carry significant risk that the investor will lose some or all of the invested capital. For example,

investments in company stock shares put capital at risk. The value of a stock share depends on what someone is

willing to pay for it at a certain point in time. Unlike capital invested in a savings account, the capital value (price) of

a stock share constantly changes. If the price is relatively stable, the stock is said to have low volatility. If the price

often changes a great deal, the stock has high volatility. All stock shares have some volatility, and the change in

price directly affects ROI for stock investments.

Stock returns are usually calculated for holding periods such as a month, a quarter or a year.

Reinvestment when capital is at risk: rate of return and yield

Example: Stock with low volatility and a regular quarterly dividend, reinvested

End of: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Dividend $1 $1.01 $1.02 $1.03

Stock Price $98 $101 $102 $99

Shares Purchased 0.010204 0.01 0.01 0.010404

Total Shares Held 1.010204 1.020204 1.030204 1.040608

Investment Value $99 $103.04 $105.08 $103.02

Quarterly ROI -1% 4.08% 1.98% -1.96%
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Rate of return 21

Yield is the compound rate of return that includes the effect of reinvesting interest or dividends.

To the right is an example of a stock investment of one share purchased at the beginning of the year for $100.

The quarterly dividend is reinvested at the quarter-end stock price.

The number of shares purchased each quarter = ($ Dividend)/($ Stock Price).

The final investment value of $103.02 is a 3.02% Yield on the initial investment of $100. This is the compound

yield, and this return can be considered to be the return on the investment of $100.

To calculate the rate of return, the investor includes the reinvested dividends in the total investment. The investor

received a total of $4.06 in dividends over the year, all of which were reinvested, so the investment amount increased

by $4.06.

Total Investment = Cost Basis = $100 + $4.06 = $104.06.

Capital gain/loss = $103.02 - $104.06 = -$1.04 (a capital loss)

($4.06 dividends - $1.04 capital loss ) / $104.06 total investment = 2.9% ROI

The disadvantage of this ROI calculation is that it does not take into account the fact that not all the money was

invested during the entire year (the dividend reinvestments occurred throughout the year). The advantages are: (1) it

uses the cost basis of the investment, (2) it clearly shows which gains are due to dividends and which gains/losses aredue to capital gains/losses, and (3) the actual dollar return of $3.02 is compared to the actual dollar investment of

$104.06.

For U.S. income tax purposes, if the shares were sold at the end of the year, dividends would be $4.06, cost basis of

the investment would be $104.06, sale price would be $103.02, and the capital loss would be $1.04.

Since all returns were reinvested, the ROI might also be calculated as a continuously compounded return or

logarithmic return. The effective continuously compounded rate of return is the natural log of the final investment

value divided by the initial investment value:

is the initial investment ($100)

is the final value ($103.02)

.

Mutual fund and investment company returns

Mutual funds, exchange-traded funds (ETFs), and other equitized investments (such as unit investment trusts or

UITs, insurance separate accounts and related variable products such as variable universal life insurance policies and

variable annuity contracts, and bank-sponsored commingled funds, collective benefit funds or common trust funds)

are essentially portfolios of various investment securities such as stocks, bonds and money market instruments which

are equitized by selling shares or units to investors. Investors and other parties are interested to know how the

investment has performed over various periods of time.

Performance is usually quantified by a fund's total return. In the 1990s, many different fund companies were

advertising various total returnssome cumulative, some averaged, some with or without deduction of sales loads or

commissions, etc. To level the playing field and help investors compare performance returns of one fund to another,

the U.S. Securities and Exchange Commission (SEC) began requiring funds to compute and report total returns

based upon a standardized formulaso called "SEC Standardized total return" which is the average annual total

return assuming reinvestment of dividends and distributions and deduction of sales loads or charges. Funds may

compute and advertise returns on other bases (so-called "non-standardized" returns), so long as they also publish no

less prominently the "standardized" return data.

Subsequent to this, apparently investors who'd sold their fund shares after a large increase in the share price in the

late 1990s and early 2000s were ignorant of how significant the impact of income/capital gain taxes was on their

fund "gross" returns. That is, they had little idea how significant the difference could be between "gross" returns
http://en.wikipedia.org/w/index.php?title=U.S._Securities_and_Exchange_Commissionhttp://en.wikipedia.org/w/index.php?title=Variable_annuityhttp://en.wikipedia.org/w/index.php?title=Variable_universal_life_insurancehttp://en.wikipedia.org/w/index.php?title=Separate_accounthttp://en.wikipedia.org/w/index.php?title=Exchange-traded_fundhttp://en.wikipedia.org/w/index.php?title=Mutual_fund


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Rate of return 22

(returns before federal taxes) and "net" returns (after-tax returns). In reaction to this apparent investor ignorance, and

perhaps for other reasons, the SEC made further rule-making to require mutual funds to publish in their annual

prospectus, among other things, total returns before and after the impact of U.S federal individual income taxes. And

further, the after-tax returns would include 1) returns on a hypothetical taxable account after deducting taxes on

dividends and capital gain distributions received during the illustrated periods and 2) the impacts of the items in #1)

as well as assuming the entire investment shares were sold at the end of the period (realizing capital gain/loss on

liquidation of the shares). These after-tax returns would apply of course only to taxable accounts and not to

tax-deferred or retirement accounts such as IRAs.

Lastly, in more recent years, "personalized" investment returns have been demanded by investors. In other words,

investors are saying more or less the fund returns may not be what their actual account returns are based upon the

actual investment account transaction history. This is because investments may have been made on various dates and

additional purchases and withdrawals may have occurred which vary in amount and date and thus are unique to the

particular account. More and more fund and brokerage firms have begun providing personalized account returns on

investor's account statements in response to this need.

With that out of the way, here's how basic earnings and gains/losses work on a mutual fund. The fund records

income for dividends and interest earned which typically increases the value of the mutual fund shares, while

expenses set aside have an offsetting impact to share value. When the fund's investments increase in market value, so

too does the value of the fund shares (or units) owned by the investors. When investments increase (decrease) in

market value, so too the fund shares value increases (or decreases). When the fund sells investments at a profit, it

turns or reclassifies that paper profit or unrealized gain into an actual or realized gain. The sale has no affect on the

value of fund shares but it has reclassified a component of its value from one bucket to another on the fund

bookswhich will have future impact to investors. At least annually, a fund usually pays dividends from its net

income (income less expenses) and net capital gains realized out to shareholders as an IRS requirement. This way,

the fund pays no taxes but rather all the investors in taxable accounts do. Mutual fund share prices are typically

valued each day the stock or bond markets are open and typically the value of a share is the net asset value of the

fund shares investors own.

Total returns

This section addresses only total returns without the impact of U.S. federal individual income and capital gains taxes.

Mutual funds report total returns assuming reinvestment of dividend and capital gain distributions. That is, the

dollar amounts distributed are used to purchase additional shares of the funds as of the reinvestment/ex-dividend

date. Reinvestment rates or factors are based on total distributions (dividends plus capital gains) during each period.
http://en.wikipedia.org/w/index.php?title=Net_asset_valuehttp://en.wikipedia.org/w/index.php?title=IRS


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Rate of return 23

Average annual total return (geometric)

US mutual funds are to compute average annual total return as prescribed by the U.S. Securities and Exchange

Commission (SEC) in instructions to form N-1A (the fund prospectus) as the average annual compounded rates of

return for 1-year, 5-year and 10-year periods (or inception of the fund if shorter) as the "average annual total return"

for each fund. The following formula is used:[4]

Where:

P = a hypothetical initial payment of $1,000.

T = average annual total return.

n = number of years.

ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1-, 5-, or 10-year

periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).

Solving for T gives

Example

Example: Balanced mutual fund during boom times with regular annual dividends,

reinvested at time of distribution, initial investment $1,000 at end of Year 0, share price

$14.21

Year 1 Year 2 Year 3 Year 4 Year 5

Dividend Per Share $0.26 $0.29 $0.30 $0.50 $0.53

Capital Gain Distribution Per Share $0.06 $0.39 $0.47 $1.86 $1.12

Total Distribution Per Share $0.32 $0.68 $0.77 $2.36 $1.65

Share Price At End Of Year $17.50 $19.49 $20.06 $20.62 $19.90

Reinvestment Factor 1.01829 1.03553 1.03975 1.11900 1.09278

Shares Owned Before Distribution 70.373 71.676 74.125 76.859 84.752

Total Distribution $22.52 $48.73 $57.10 $181.73 $141.60

Share Price At Distribution $17.28 $19.90 $20.88 $22.98 $21.31

Shares Purchased 1.303 2.449 2.734 7.893 6.562

Shares Owned After Distribution 71.676 74.125 76.859 84.752 91.314

Total Return = (($19.90 x 1.09278) / $14.21) - 1 = 53.04%

Average Annual Total Return (geometric) = ((($19.90 x 91.314) / $1,000) ^ (1 / 5)) - 1 = 12.69%

Using a Holding Period Return calculation, after 5 years, an investor who reinvested owned 91.314 shares valued at

$19.90 per share. ((($19.90 x 91.314) / $1,000) - 1) / 5 = 16.34% return. An investor who did not reinvest received

total cash payments of $5.78 per share. ((($19.90 + $5.78) / $14.21) - 1) / 5 = 16.14% return.

Mutual funds include capital gains as well as dividends in their return calculations. Since the market price of a

mutual fund share is based on net asset value, a capital gain distribution is offset by an equal decrease in mutual fund

share value/price. From the shareholder's perspective, a capital gain distribution is not a net gain in assets, but it is arealized capital gain.
http://en.wikipedia.org/w/index.php?title=Holding_Period_Returnhttp://en.wikipedia.org/w/index.php?title=U.S._Securities_and_Exchange_Commissionhttp://en.wikipedia.org/w/index.php?title=U.S._Securities_and_Exchange_Commission


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Rate of return 24

Summary: overall rate of return

Rate of Return and Return on Investment indicate cash flow from an investment to the investor over a specified

period of time, usually a year.

ROI is a measure of investment profitability, not a measure of investment size. While compound interest and

dividend reinvestment can increase the size of the investment (thus potentially yielding a higher dollar return to the

investor), Return on Investment is a percentage return based on capital invested.

In general, the higher the investment risk, the greater the potential investment return, and the greater the potential

investment loss.

References

[1] Damato,Karen. Doing the Math: Tech Investors' Road to Recovery is Long. Wall Street Journal, pp.C1-C19, May 18, 2001

[2] A. A. Groppelli and Ehsan Nikbakht (2000).Barron's Finance, 4th Edition. New York. pp. 442456. ISBN 0-7641-1275-9.

[3] Barron's Finance. pp. 151163.

[4] U.S. Securities and Exchange Commission (1998). "Final Rule: Registration Form Used by Open-End Management Investment Companies:

Sample Form and instructions" (http://www.sec.gov/rules/final/33-7512f.htm#E12E2). .

Further reading

A. A. Groppelli and Ehsan Nikbakht.Barrons Finance, 4th Edition. New York: Barrons Educational Series, Inc.,

2000. ISBN 0-7641-1275-9

Zvi Bodie, Alex Kane and Alan J. Marcus.Essentials of Investments, 5th Edition. New York: McGraw-Hill/Irwin,

2004. ISBN 0-07-251077-3

Richard A. Brealey, Stewart C. Myers and Franklin Allen.Principles of Corporate Finance, 8th Edition.

McGraw-Hill/Irwin, 2006

Walter B. Meigs and Robert F. Meigs.Financial Accounting, 4th Edition. New York: McGraw-Hill Book

Company, 1970. ISBN 0-07-041534-X Bruce J. Feibel.Investment Performance Measurement. New York: Wiley, 2003. ISBN 0471268496

External links

ROR Nomenclature and usage by different products (http://www.retailinvestor.org/return.html)
http://www.retailinvestor.org/return.htmlhttp://www.sec.gov/rules/final/33-7512f.htm#E12E2http://en.wikipedia.org/w/index.php?title=U.S._Securities_and_Exchange_Commissionhttp://en.wikipedia.org/w/index.php?title=Karen_Damato


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Return on assets 25

Return on assets

The return on assets (ROA) percentage shows how profitable a company's assets are in generating revenue.

ROA can be computed as:

[1]

This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from

each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The

number will vary widely across different industries. Return on assets gives an indication of the capital intensity of

the company, which will depend on the industry; companies that require large initial investments will generally have

lower return on assets.

Usage

Return on assets is an indicator of how profitable a company is before leverage, and is compared with companies in

the same industry. Since the figure for total assets of the company depends on the carrying value of the assets, some

caution is required for companies whose carrying value may not correspond to the actual market value. Return on

assets is a common figure used for comparing performance of financial institutions (such as banks), because the

majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not

useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as

reserve requirements in the insurance and banking industries).

Return on assets is one of the elements used in financial analysis using the Du Pont Identity.

References

[1] Susan V. Crosson; Belverd E., Jr Needles; Needles, Belverd E.; Powers, Marian (2008).Principles of accounting. Boston: Houghton Mifflin.

p. 209. ISBN 0-618-73661-1.

External links

Return On Assets - ROA (http://www.investopedia.com/terms/r/returnonassets.asp)
http://www.investopedia.com/terms/r/returnonassets.asphttp://en.wikipedia.org/w/index.php?title=Du_Pont_Identityhttp://en.wikipedia.org/w/index.php?title=Insurancehttp://en.wikipedia.org/w/index.php?title=Bankhttp://en.wikipedia.org/w/index.php?title=Financial_institutionhttp://en.wikipedia.org/w/index.php?title=Market_valuehttp://en.wikipedia.org/w/index.php?title=Book_valuehttp://en.wikipedia.org/w/index.php?title=Gearinghttp://en.wikipedia.org/w/index.php?title=Capital_intensity


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Return on assets Du Pont

DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont Model or the DuPont method)

is an expression which breaks ROE (Return On Equity) into three parts.

The name comes from the DuPont Corporation that started using this formula in the 1920s.

Basic formula

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net

profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)

Operating efficiency (measured by profit margin)

Asset use efficiency (measured by asset turnover)

Financial leverage (measured by equity multiplier)

ROE analysis

The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into

three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by

comparison with companies in similar industries (or between industries).

The Du Pont identity, however, is less useful for some industries, such as investment banking, that do not use certain

concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they

also respect the underlying structure of the Du Pont identity.

Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by definition true.

ExamplesHigh turnover industries

Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively

moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their

assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset

turnover may be studied extremely carefully for signs of under-, or, over-performance. For example, same store sales

of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores

(rather than showing improved performance by continually opening new stores).

High margin industriesOther industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a

higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may

be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of

ROE.

High leverage industries

Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. In contrast, however,

many other industries would see high levels of leverage as unacceptably risky. Du Pont analysis enables the third

party (relying primarily on the financial statements) to compare leverage with other financial elements that determine

ROE among similar companies.
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ROI and ROE ratio

The return on investment (ROI) ratio developed by DuPont for its own use is now used by many firms to evaluate

how effectively assets are used. It measures the combined effects of profit margins and asset turnover.[1]

The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2] Decomposing the ROE into

various factors influencing company performance is often called the Du Pont system.[3]

Where

Net profit = net profit after taxes

Equity = shareholders' equity

EBIT = Earnings before interest and taxes

Sales = Net sales

This decomposition presents various ratios used in fundamental analysis.

The company's tax burden is (Net profit Pretax profit). This is the proportion of the company's profits retained

after paying income taxes.

The company's interest burden is (Pretax profit EBIT). This will be 1.00 for a firm with no debt or financial

leverage.

The company's operating profit margin or return on sales (ROS) is (EBIT Sales). This is the operating profit

per dollar of sales.

The company's asset turnover (ATO) is (Sales Assets).

The company's leverage ratio is (Assets Equity), which is equal to the firm's debt to equity ratio + 1. This is a

measure of financial leverage.

The company's return on assets (ROA) is (Return on sales x Asset turnover).

The company's compound leverage factor is (Interest burden x Leverage).

ROE can also be stated as:[4]

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

ROE = Tax burden x ROA x Compound leverage factor

Profit margin is (Net profit Sales), so the ROE equation can be restated:

References

[1] Groppelli, Angelico A.; Ehsan Nikbakht (2000).Finance, 4th ed. Barron's Educational Series, Inc.. pp. 444445. ISBN 0764112759.

[2] Groppelli, Angelico A.; Ehsan Nikbakht (2000).Finance, 4th ed. Barron's Educational Series, Inc.. p. 444. ISBN 0764112759.

[3] Bodie, Zane; Alex Kane and Alan J. Marcus (2004).Essentials of Investments, 5th ed. McGraw-Hill Irwin. pp. 458459. ISBN 0072510773.

[4] Bodie, Zane; Alex Kane and Alan J. Marcus (2004).Essentials of Investments, 5th ed. McGraw-Hill Irwin. p. 460. ISBN 0072510773.

External links

Decoding DuPont Analysis (http://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.

asp)
http://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asphttp://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asphttp://en.wikipedia.org/w/index.php?title=Compound_leverage_factorhttp://en.wikipedia.org/w/index.php?title=Debt_to_equity_ratiohttp://en.wikipedia.org/w/index.php?title=Asset_turnoverhttp://en.wikipedia.org/w/index.php?title=Return_on_saleshttp://en.wikipedia.org/w/index.php?title=Debthttp://en.wikipedia.org/w/index.php?title=Taxhttp://en.wikipedia.org/w/index.php?title=Fundamental_analysishttp://en.wikipedia.org/w/index.php?title=Earnings_before_interest_and_taxes


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Return on net assets 28

Return on net assets

The return on net assets (RONA) is a measure of financial performance of a company which takes the use of assets

into account.

Formula

Return on net assets = Profit after tax ( also known as net income) / ( Fixed assets + working capital )

In a manufacturing sector this is also calculated as:

Return on net assets = (plant revenue - costs) / net assets

Return on capital

Return on capital (ROC) is a ratio used in finance, valuation, and accounting. The ratio is estimated by dividing the

after-tax operating income (NOPAT) by the book value of invested capital.

Formula

This differs from ROIC. Return on invested capital (ROIC) is a financial measure that quantifies how well a

company generates cash flow relative to the capital it has invested in its business. It is defined as net operating profit

less adjusted taxes divided by invested capital and is usually expressed as a percentage. In this calculation, capital

invested includes all monetary capital invested: long-term debt, common and preferred shares.

When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of

capital), the company is creating value; when it is less than the cost of capital, value is destroyed.

ROIC formula

Note that the numerator in the ROIC fraction does not subtract interest expense, because denominator includes debt

capital.

See also Cash flow return on investment (CFROI)

Profitability

Rate of profit

Profit maximization

Tendency of the rate of profit to fall

Return of capital

Return on investment (ROI)

Return on net assets (RONA)

Return on revenue (ROR), also Return on sales (ROS) Risk adjusted return on capital (RAROC)
http://en.wikipedia.org/w/index.php?title=Return_on_saleshttp://en.wikipedia.org/w/index.php?title=Return_on_revenuehttp://en.wikipedia.org/w/index.php?title=Return_on_investmenthttp://en.wikipedia.org/w/index.php?title=Return_of_capitalhttp://en.wikipedia.org/w/index.php?title=Tendency_of_the_rate_of_profit_to_fallhttp://en.wikipedia.org/w/index.php?title=Profit_maximizationhttp://en.wikipedia.org/w/index.php?title=Rate_of_profithttp://en.wikipedia.org/w/index.php?title=Profit_%28accounting%29http://en.wikipedia.org/w/index.php?title=Interest_expensehttp://en.wikipedia.org/w/index.php?title=Weighted_average_cost_of_capitalhttp://en.wikipedia.org/w/index.php?title=Weighted_average_cost_of_capitalhttp://en.wikipedia.org/w/index.php?title=Cost_of_capitalhttp://en.wikipedia.org/w/index.php?title=Percentagehttp://en.wikipedia.org/w/index.php?title=Invested_capitalhttp://en.wikipedia.org/w/index.php?title=NOPLAThttp://en.wikipedia.org/w/index.php?title=NOPLAThttp://en.wikipedia.org/w/index.php?title=Invested_capitalhttp://en.wikipedia.org/w/index.php?title=Book_valuehttp://en.wikipedia.org/w/index.php?title=NOPAThttp://en.wikipedia.org/w/index.php?title=Working_capitalhttp://en.wikipedia.org/w/index.php?title=Fixed_assetshttp://en.wikipedia.org/w/index.php?title=Net_incomehttp://en.wikipedia.org/w/index.php?title=Net_assets


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Return on capital 29

References

Risk adjusted return on capital

Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysingrisk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept

was developed by Bankers Trust and principal designer Dan Borge in the late 1970s.[1]

Note, however, that more and

more Return on risk Adjusted Capital (RORAC) is used as a measure, whereby the risk adjustment of Capital is

based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel II.

Basic formula

RAROC = (Expected Return)/(Economic Capital)[2]

or

RAROC = (Expected Return)/(Value at risk)[2]

Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of riskadjusted return to economic capital. The economic capital is the amount of money which is needed to secure the

survival in a worst case scenario, it is a buffer against expected shocks in market values. Economic capital is a

function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on

risk improves the capital allocation across different functional areas of banks, insurance companies, or any business

in which capital is placed at risk for an expected return above the risk-free rate.

RAROC system allocates capital for 2 basic reasons:

1. Risk management

2. Performance evaluation

For risk management purposes, the main goal of allocating capital to individual business units is to determine the

bank's optimal capital structurethat is economic capital allocation is closely correlated with individual business

risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic

value added of each unit.

References

[1] Herring, Richard; Diebold, Francis X.; Doherty, Neil A. (2010). The Known, the Unknown, and the Unknowable in Financial Risk

Management: Measurement and Theory Advancing Practice. Princeton, N.J: Princeton University Press. p. 347.

[2] Quantifying Risk in the Electricity Business: A RAROC-based Approach (http://www.pstat.ucsb.edu/research/papers/report10_2004[1].

pdf)

"An Introduction to Broad Based Credit Engineering" By Morton Glantz

External links

RAR

ba financial ratios

Documents