Chapter 12
Using Accounting Information
370
Although not shown in Figure 12.14, we need to know the balance of shareholders’ equity at
December 29, 2012 to calculate the average shareholders’ equity for 2013. Assume that the balance
on this date was $56,700,000. Then, the calculations of ROE for Second Cup in 2013 and 2014
are shown in Figure 12.19.
2014
2013
Net Income (Loss)
($27,032)
($7,369)
Average Shareholders’ Equity
(1)
$35,479
$51,332
Return on Equity
−
76%
−
14%
Industry Average
13%
16%
(1) Average Shareholders’ Equity for 2013: ($56,700 + $45,964) ÷ 2 = $51,332
Average Shareholders’ Equity for 2014: ($45,964 + $24,994) ÷ 2 = $35,479
_______________
Figure 12.19
A high ROE is desirable because it means that investors made a good decision by investing in the
company. Shareholders like to see a return that is as good or better than they could have received
by investing elsewhere. A negative ROE indicates that shareholders actually lost money on their
investments over the year. It also deters investors from investing more money at the risk of losing
it. Second Cup’s return on equity has gone from bad to worse recently while other companies in the
same industry have been able to generate a positive return for their shareholders.
One of the most important assessments that owners of a business can make is to know if they are
getting a decent return on their investment. How is this done and how do they know if they are
getting their money’s worth out of the business?
Any determination of return on investment revolves around shareholders’ equity. In other words, how much
cash would the owners have left if they sold all the assets of the business and paid off all their debt? Given
that this is a hypothetical question, and that the owners do not have to sell everything to assess the return
on investment, there are other ways of assessing the value of the investment in the business.
For example, the owners could ask themselves another theoretical question: Should we keep our money in
the business, or put it elsewhere? Safe investments such as fixed deposit accounts come with relatively lower
returns on investment. Investing in a friend’s new business comes with a potentially much larger return on
investment—but also with greater risk.
In fact, a general rule of thumb can be applied to assessing return on investment associated with certain
levels of risk. Generally speaking, investments in publicly traded companies come with the expectation
of a return ranging from 15% – 25%. Alternatively, the rate of return associated with private companies
is expected to be much higher. In fact, it is not unusual to expect a rate of return of 100% or more for an
investment in a small private company.
As with most things in life, everything comes at a price. With return on investment, the price can be a matter
of risk. If owners want a better return, they must have a greater tolerance for risk.
IN THE REAL WORLD
