Another
widely reported accounting measure of return
is return on assets, where after-tax operating
income is divided by the book value of total
assets, rather than the book value of capital.9
There
are two problems with this computation and
they can be seen by using a simplified version
of an accounting balance sheet in figure 2:
Figure
2: Accounting Balance Sheet
In
the return on assets computation, we are using
the sum of the assets, thus yielding a value
higher than the capital invested in the return
on capital computation:
Thus,
the return on assets will be lower than the
return on capital. By itself, this would not
be an issue if all we did was compare returns
on assets across firms. However, the return
on assets cannot be compared to the cost of
capital, since that cost is based on the cost
of debt and equity (and does not incorporate
current liabilities and other non-interest
bearing liabilities) invested in assets. The
other difference is that cash is a part of
total assets and is left in the base, even
though operating income does not include the
interest income from cash.
Assessment
of Accounting
Returns
Should we trust accounting returns? The answer
lies in whether we believe that there is information
in accounting earnings and book value. If
we do, there is value to estimating accounting
returns, though that conclusion has to be
tempered by three facts.
The
first is that the accounting return estimated
is for a single period; even if it is an accurate
assessment of that period's performance, it
may not be a good measure of returns over
the long term for an investment. The second
is that the use of book value of equity or
capital leaves the return exposed to accounting
choices made not only in the current period
but to choices made over time. In other words,
a restructuring charge taken 10 years ago
can result in a lower book value of equity
and a higher return on capital for the most
recent year. The third is that any systematic
quirks in accounting or tax rules will leave
their imprint on the return computations.
The
most sensible course of action for an analyst
is to not take accounting earnings and book
value as a given but to adjust those numbers
to get a better measure of the returns earned
by a firm on its investments. The objective,
after all, should not be estimating last year's
return with absolute precision but coming
up with a measure of return that can be useful
in forecasting future performance.
9
Some services divide net income by total assets,
which is just as meaningless a number as dividing
net income by total capital.
Return to document index
