Return on equity
Return on Equity is a measurement of the rate of return of the stockholders investment in a publicly owned company; it is calculated by dividing annualized net income by stockholders equity. Unlike some of the other measures, this one is a bit artificial for two reasons. First, owners equity bears no relation to what the owners actually paid for their stake in the company. Second, owners equity bears no relation to what they could sell it for either.
So is the measurement of return on equity useless. It still serves as a measure of a companys earning power, even if only a theoretical comparison is possible. The same limitations apply to all companies, so the ratio enables a company to company comparison, which is useful when selecting stocks. Also as with any of these metrics, the pattern of change over time Trend Reporting below enables to see a companys progress against its own history.
Measures of productivity:
These metrics are a little different as calculating them often requires numbers that do not appear on the financial statements. They are more operationally oriented, intended to measure the performance of particular resources are delivering the kind of results that will contribute to improved numbers on the income statement and balance sheet.
Backlog of firm orders:
The most important metric that does not come out of the companys general ledger is this one. It tells us how much business the company has sold that it has sold that it has yet to deliver to its customers. There is not much arithmetic to this one. It comes from the companys order entry system, it is represented in dollars of orders and it is computed like this:
Backlog of orders is equal to all firm orders received minus all orders shipped and invoiced.
For companies that ship product orders that take some time to fulfill, such as most manufacturers and many distributors, this is a crucial measure of their immediate future as well as an indicator of the success of their sales team in their efforts to keep the production capacity of the company humming. Like any good metric, it comes with good news and bad news.
If backlog is falling over time, it means the company is not bringing in new orders as fast as it is filling the ones it had. A trend like that cannot continue indefinitely or the company will eventually have no orders to fill. It means either the production department is super efficient or the sales department is not. Neither is a good thing, even if the company is ringing up nice sales at the time it ships all those orders leaving the shipping dock.
If backlog is rising over time, that could be either good news or bad news. If sales is bringing in orders so fast that production cannot fill them, customers will be unhappy and the company may lose customers. This will tend to hamper the sales departments continued success in overwhelming production, but for all the wrong reasons.
The objective of sales should be to continue to build the backlog, while the objective of production and this includes the sales people and drivers in the distributors offices as well as the service providers of service businesses should be to deliver on orders faster than sales can bring more in. The role of top management then is to beef up either side that is falling behind in this tug of war, so that backlog is where they want it to be.
Shareholders equity on balance sheet:
Loans from stockholders
This is special category of loan, most often seen on the balance sheets of privately owned companies operated by the owners. For some privately owned companies, this is how owners put money into the company when it needs it and take it back out again when it does not. All too frequently, however, business conditions may not improve soon, so loans from stockholders may stay on the balance sheet for years. In fact, banks and other outside lenders may actually require that such balances remain unpaid as long as the company has outside loans. Thus these amounts can end up looking more like owners equity than loans to the company, often a frustrating reality for entrepreneurs and small business owners, who had hoped to be repaid at some point.
Ownership comes in various forms
Owners equity or stockholders equity or capital is the owners stake in the business. It includes what they have invested to launch, to finance, or to refinance the company and what the company has earned over its existence.
As noted above, it can also include amounts that owners have loaned to the business that they cannot get back because of some subsequent loan agreement with a bank or other lending source. Such loans are always shown in the liabilities section of the balance sheet and never in the equity section, because they are not legally investment capital until and unless ultimate repayment is formally relinquished by legal means. Captions that may appear in this section include the following.
Capital stock and contributed capital
Capital stock is the amount paid into the company by investors to purchase stock, at some nominal amount per share. It is usually a small part of what the investors actually paid, for legal reasons. Investors usually pay more for a share of stock than the amount shown under this caption; the balance of the proceeds is reported under a heading such as contributed capital or some similar description. These two amounts, when combined, represent the total amount formally contributed by investors to finance the company.
Retained earnings
Every company from its inception develops a history of profits and losses. Profits add to retained earnings and losses reduce retained earnings. If a company has operated with overall profitability, it will have accumulated a substantial amount of earnings over time. If it is a proprietorship or a partnership, these earnings are usually taxable to the owners immediately, so they are typically paid out to the owners each year, as dividends or distributions of profits.
However, if the company is a corporation, its owners will not generally be taxed on the companys accumulated profits until the company chooses to distribute those earnings to its owners in the form of cash dividends. In the interim, the accumulated earnings not distributed to its owners are shown as, logically enough, retained earnings.
Earnings are retained in the business for other reasons than just to avoid paying taxes on them, including enabling the business to retain cash for expansion or to purchase land, buildings and equipment to facilitate its operations. The company may also be a building a war chest to enable it to:
1 Buy other companies
2 Protect itself against a possible catastrophe
3 Repurchase its own stock, when prices are low
4 Ensure adequate working capital to run the business
Some companies actually have had negative retained earnings, because they have lost more money than they have made over their existence. Usually this can be recognized by the caption deficit in retained earnings. This is usually a good clue that might not want to buy their stock just yet, as they may not yet have figured out how to make money in their business.
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