Business Financial Metrics – #3

Posted: February 6, 2013 in Business Financial Statements, Up-and-running Business
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The third metric is rather opaque so I will present it in the context of the small business owner – Return on (small business) Equity.  On paper, this is a simple metric:      Small Business ROE

Net income (after tax) / Average shareholder equity plus shareholder loans.

Remember that a bank considers a shareholder loan as a part of a shareholder’s investment in a business. That is why they insist on the shareholder loan being a part of the loan covenant that restricts dividend payments and repayment of shareholder loans until such time as the bank is satisfied that the bank’s capital is sufficiently protected.

A simple mathematical calculation will show how the ratio is calculated:

Shareholder loan:           Current year       $75,000  Prior year  $75,000

Shareholder equity:      Current year     $155,000  Prior year  $125,000

Net profit:   Current year        $30,000

The average shareholder equity and shareholder loans is $75,000 (loans) plus $155,000 + $125,000 / 2 = $140,000 (average shareholder equity)

The ROE is:    $30,000 / $140,000 + $75,000 =  14%

So the ROE for our fictitious company is 14%. This looks great on the surface. However this needs to be compared to the Cost of Equity Capital for a small business. The Cost of Equity Capital for a small business is not easy to compute and may not be intuitive. I will expand on this in the next post.

 

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