Return analysis is different from profitability analysis because usually return is measured as a profitability of the assets, investments, capital or other similar asset group but not as a profitability of the revenues.
Mostly return refers to some kind of profit (or earnings) that is gained from particular investment during some period. Such investment can be investment in stocks, bonds or other securities as well such investment may represent some investment project of a manufacturing company, for example, new production line. Actually, any money spending on purpose to earn more money in the future is some kind of investment and it has to bring some return. The problem is only to measure that return correctly, because there are many ways to do that. It is even more difficult because return may mean not only the profit or earnings but also increase in value, dividends, interests or other forms of return.
How to Calculate Return
Basically when return is calculated, profit is divided by investment amount. Many types of profits are used for these calculations but the most popular is net profit. Yet, the invested amount sometime is not an easy indicator to find too, especially if real investments were made many years ago. For example, some strategic investor bought a construction company few years ago for 100 mUSD but company was established 40 years ago and initial investment was equal to 15 mUSD, and now company’s assets exceed 150 mUSD but company’s equity is only 50 mUSD. And this company has earned 20 mUSD net profit for the last year. So what the return of such company is? Well, it depends what kind of return. We could get different numbers for different ratios, for example, ROE would be 40%, ROA would be 13%, when ROI(C) depending on methodology could be 20%.
As you see, there are many ratios that can be used to measure return and it is hard to say which one is the best, because it would depend on situation. Most of the times you need to calculate more than one ratio, but the most accurate ratios are those that are based on real market values rather than some data from balance sheet.
These are the main return measurement ratios:
- Return on investment (ROI) is ratio that compares total value increase of investment and money spent for that investment. It is a practical return ratio but not always exact data are available.
- Return on asset (ROA) is a good ratio to measure what profits are earned compared to company’s assets. Normally assets of similar businesses should bring similar earnings.
- Return on equity (ROE) is very popular ratio in theoretical calculations because high return on equity may indicate high potential for growth. ROE is important ratio for shareholders but has to be used very carefully in practice.
- Internal rate of return (IRR) is a different ratio and is used for projects that have predictable duration. IRR is calculated for the project for all the period. It is a good return ratio when investment projects have to be selected.
- Return on invested capital (ROIC) ratio measures return in similar way as ROA or ROE only more specific financial data are used. However, there are many modifications of this return ratio.
- Return on capital employed (ROCE) ratio is very similar to ROIC, however, there are a lot of modifications of this ratio.