Return on Assets is calculated by dividing Net Profits by Assets. Along similar lines, you can divide Net Profits by Investment (defined as long-term debt, other long-term liabilities, plus equity) or Equity to compute Return on Investment or Return on Equity, respectively.

To truly see how this data works, it's best to think about what it shows, rather than the formula for calculation. All of these ratios, in one way or another, seek to measure how much profit management has been able to earn from the capital it is using. The most basic benchmark against which you can evaluate a return on capital is the U.S. Treasury bond rate, which tells us how much can be earned if all capital were to be invested in these securities. It's regarded as a risk-free investment since there's no uncertainty at all as to the dollar amount of income that will be received as well as the timing of all receipts (interest income and repayment of principal). If a business is consistently unable to earn as much from its capital as could be obtained from a risk free U.S. government bonds, shareholders would be well within their rights to believe they'd do better if they liquidated the firm, divided up the proceeds, and invested in treasuries. Any excess return earned by running a business, instead of owning Treasuries, is known as a "risk premium."

When evaluating risk premiums, it's best to avoid doing so in a rigid manner. Unlike a treasury portfolio, the world of business is subject to ups and downs. Anyone who invests in stocks must understand and be prepared to accept this. Hence at times, corporate returns will trail risk-free rates. Shareholder are compensated for accepting periodic bad years by the fact that they can earn much higher returns if they stay in stocks for the long term. And indeed, this expectation has been satisfied in this generation. Long-term corporate returns have been superior to those that could be earned from risk-free instruments (meaning that the good years do, in fact, offset periodic bad intervals). Because returns fluctuate, use the Trailing Twelve Month data you see here to give you a sense of whether the present is a strong or sluggish period for the company, its industry, its sector and the S&P 500. But to assess how effectively management utilizes the capital available to it, use the 5-Year Average Returns.

You'll notice that Market Guide presents three different ratios in this section. All three ratios use Net Profit as the measure of "return." The differences are in how we measure the amount of capital employed in the business.

• Return on Equity shows how much return management has earned on the capital that is actually owned by the shareholders; the owners of the business. Our starting point is the total of all assets employed in the business. From that, we subtract those assets that are devoted to current working capital (i.e., money that is owed to vendors, or money owed to short-term trade creditors to help the company bridge the period between purchase of inventory and receipt of proceeds from sale of finished goods). We also subtract long-term liabilities. What's left over is referred to as Shareholder's Equity.
  
  
  • Assume a group pools together $100 million to form a business. They hire a management team to run it. The business generates a Net Profit of $10 million. Return on Equity is 10% ($10 million of Profit divided by $100 million of Equity).
  
  
• Return on Investment shows how much return management has earned on all long-term capital; that which is owned by the shareholders and that which is contributed by long-term creditors. The capital markets exist for the purpose of matching investors who wish to supply capital with those who have the skills and vision to run businesses but are in need of more capital than they can invest on their own. There are two approaches a business person can follow when raising capital. One is to seek others who wish to be co-owners (i.e., shareholders). These co-owners share fully when the company prospers, and see their investment deteriorate when the company falters. There is another type of capital supplier who is willing to miss out on the full benefits of the company's prosperity in exchange for the privilege of realizing a more stable return, in good years and lean years. Such individuals make long-term loans to the company.
  
  
  • Assume a group pools together $100 million to form the same sort of business as in the example above, and decide to supplement their own funds by borrowing an additional $50 million on a long-term basis. The company earns a Net Profit of $15 million. Return on Investment is 10% ($15 million of Profit divided by $150 million of capital, consisting of $100 million supplied by owners and $50 million supplied by long-term lenders). Interestingly, though, Return on Equity is now 15% ($15 million of Profit divided by $100 million of Equity). This is an example of the way in which a business owner can increase the return on his/her capital through the skillful use of borrowed money.
    
    
• Return on Assets shows how much return management has earned on all assets available to it, from all sources. In examining all capital resources available to a business manager, we can, as a practical matter, go even beyond owner's capital and long-term liabilities. A talented manager is also able to make use of assets available only for a year or less (known as current liabilities). Examples include short-term debt or trade accounts payable. In other words, if a bill is due in sixty days, and the company already has the money in its possession, it may use those funds in the business until the last possible moment.
  
  
  • Assume a group pools together $100 million to form the same sort of business as in the example above, and decides to supplement their own funds by borrowing an additional $50 million on a long-term basis. Also, the company, in the course of its day-to-day operations, usually has about $20 million of funds that it needs to pay to vendors within sixty days. By the time that money is paid, the company will have accumulated another $20 million, more or less in accounts payable that will be paid sixty days further into the future. On a full-year basis, the company has, on average, $20 million of this short-term money available to it. The business generates a Net Profit of $17 million. Return on Assets is 10% ($17 million of Profit divided by $170 million of capital, consisting of $100 million supplied by owners and $50 million supplied by long-term lenders and $20 million of payables the company can use before writing a check to vendors). Interestingly, though, Return on Investment is now 11.3% ($17 million of Profit divided by $150 million of long-term and short-term capital). Return on Equity has jumped to 17% ($17 million of profit divided by $100 million of equity).
    
    

These examples demonstrate that Retrun on Equity (owner's capital) reflects a combination of business performance and skillful financial management. In all three examples, business performance alone gave us returns on capital equal to 10%. But we saw that the Return on Equity was increased to 15% through effective use of long-term liabilities. Skillful use of short-term capital generated a still-higher 17% return.