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Calculate Management Effectiveness Ratios

Management effectiveness ratios tell you whether company management uses shareholders’ equity and company assets to produce an acceptable rate of return.

Even with the best products or services, companies have trouble delivering strong long-term growth unless their management makes sure that everything operates effectively and efficiently. Management effectiveness ratios compare financial measures from company financial statements to evaluate management performance. Of all the fundamental criteria that long-term investors consider, one of the most important is return on equity (ROE), which is a basic test of how well a company’s management uses its money—are they increasing the overall value of the business at an acceptable rate? Return on assets (ROA) takes another view of management’s effectiveness by illustrating how much profit the company earns for every dollar of its assets, such as money in the bank, accounts receivable, property, equipment, inventory, and furniture. One reason to consider ROA as well as ROE is that the latter can make high-debt companies look more effective than low-debt firms with the same earnings and assets.

Evaluating Return on Equity

Calculate ROE with the formula in Example 4-30.

Example 4-30. Formula for ROE

% Return on Equity = (Annual Net Income / Average Shareholders' Equity) * 100

Understanding Equity

The concept of equity is sometimes hard to grasp, so here’s a brief lesson. Simply defined, shareholders’ ...