Net Income To Equity Ratio
:Net Income |
= |
119,487 |
= |
.22 |
Stockholders Equity |
553,907 |
|||
The Net Income to Equity Ratio indicates the return on the investÂment (ROI) that the shareholders are receiving based on the equity they have in the business. In the example given, the shareholders are receiving a 22 percent return on the equity remaining in the business.
A more appropriate measure of the return on investment would be to adjust the shareholders' equity from book value to market value, by adjusting the assets of the business for any increase or decrease in their value.
For example, in the company we are analyzing, if you look in the property and equipment section, you see they own land, which is being carried at $126,150. If the land substantially appreciated to, let's say, a value of $500,000, then the book value of the company should be adjusted for this appreciation. This increases the book value by the differences between $126,150 and $500,000, or $373,850.
This means that in calcu-lating the return on investment, you should be taking $373,850 (the increase in the value of the land) plus the net equity, $553,907, totaling $927,757, divided into the earnings of $119,487, indicating a return on investment of 12.9 percent. Quite a difference from the rate of return calculated before adjusting for the appreciation in assets.
Recently I spoke with some people who had a business that was producing approximately $25,000 per year of annual income. Many years prior to this, they had purchased the real property that was occupied by their business.
The property had increased substantially, and when asked the value, they indicated it was approximately $950,000. They were using $950,000 in real estate to produce $25,000 in income, which meant that they were getting a return on the real estate of approximately 2.6 percent.
To have a better utilization of their assets, they should have sold the real estate or developed it foranother use and moved their company to quarters that were less expensive.
Businesses that are unincorporated and wish to determine the return on their investment must remember that the net income of their sole proprietorship or partnership should be reÂduced by reasonable compensation to the owners to determine the true net income to be used in the calculation.
Source: Harvey A. Goldstein, CPA , Granville Publications
