Accounting Rate of Return - ARR

finance a la shmoop. what are return on equity and return on assets? all right

return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]

the outside of sushi. it's the kissing cousin of ROA if that helps. so what

is return then in this instance huh? well it's just profits. and there's a broader

frame here to think about. if your company just made five million dollars

in profits, was that good bad middlin? well if you were a little lemonade stand

that took 50 grand to start last year and you've made this massive five

million dollar haul well then yeah wow that's awesome. but if you're Google and

this year you only made five million bucks well you have tens of billions of

dollars of capital out there trying to earn lots more while making only five

million was a huge fail. so these concepts revolve around the balance

sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]

asset side is enormous. say with the notional fifty billion dollars in assets

if you made a ten percent return on your assets or raw ROA

return on assets well that would mean you netted five billion dollars right?

ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]

there. so remember equity or shareholders equity or retained equity on the balance

sheet yeah this thing right here what equity is the retained profits after

you've started to build your company and after years and years of building your

company you would expect to have a lot of retained earnings. so what were the

returns on that equity or ROE only returns or profits number is the same as

it was in the ROA calculation only now in the denominator we have equity so if

your returns were say five billion and your retained equity was twenty billion [equations shown]

well you had a lovely twenty five percent return this year. twenty five

percent of twenty billion you know five billion. meaning that in just this one

year you grew your retained equity one massively. you've become a big harvester [man lifts weights]

of cash profits from whatever great business it is that you built. well why

do we care about ROA and ROE? well because capital efficiency

matters. it's a reflection of how efficient you are, how well you're

investing your capital how will you're able to grow the business. that is in

theory you could just sell your assets and go invest them elsewhere, like go

play an index fund in the stock market, and potentially return better profits

for your shareholders, and if you can do that well then you're probably going to

get fired. and there is precedent for this change .the airline industry there [airplane taking off]

was a time when American Airlines and United Airlines and crash Airlines owned

all their airplanes. they bought them at 50 million bucks a pop give or take but

the airline industry is a lousy business producing very low cash profits. every

time the economic cycle is good the economy is good people are buying

airline tickets up the wazoo, the Union strike and the airline's try to do

stupid things with pricing and a bunch of other things happen and all the

profits go away. anyway so one day a smart MBA employed by the airline said

hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]

them and we only need a fraction of our assets or equity or capital to produce

about the same investment returns for our shareholders. yeah and that's what

they did. so most airlines these days don't own

their own planes they lease them from the manufacturer or others and well

there haven't been any airline bankruptcies lately. and yes the airline

industry hard to find a better success story. [plane takes off]