Business & Finance

Previously we’ve talked about Porter’s Five Forces and how they impact industry profitabilities. In this episode, let’s pick two completely different industries and see how the different industry dynamics impact financial performances of companies in each industry.

The two industries we chose are paper manufacturing industry and household appliance industry. To facilitate a better understanding of our discussion, let’s first establish some basic understandings of these two industries.

Paper Manufacturing Industry

The paper manufacturing industry is not unfamiliar with most people. Almost everybody is a consumer of the paper manufacturing industry. For example, we may read newspaper, use notebooks, read magzines, etc., all of which are different kinds of paper products. In our daily lives, we may also use tissue, toilet paper, etc., and both belong to the household paper products. In addition, every day we buy all kinds of products, and they usually come in packaging, which of course is a type of paper. Therefore, everyone is a consumer of the paper manufacturing industry, but generally speaking, we don’t go to a paper manufactory to buy paper ourselves. By purchasing other kinds of products, we become consumers of paper indirectly. This may also be the reason why we don’t know that much about the paper manufacturing industry.

Put it in another way, the paper manufacturing industry has several different customer bases, i.e. buyers, such as newspaper and press, individual consumers, manufacturing companies, etc. 

Where do the raw materials of paper manufacturing come from? A really important material is wood. Most paper is produced using wood pulp. One example is toilet paper. We always see on toilet paper packaging saying “made of 100% original wood pulp”. This means the raw material of the toilet paper is wood pulp, which comes from wood.

As we know, forest resources are pretty limited worldwide. Therefore, sometimes we may not only use original wood pulp, but also recycled wood pulp, like recycled paper. It also matches the concept of being environmentally friendly. Additionally, the paper manufacturing industry worldwide also uses straw pulp or other non-wood pulp in production. 

The paper manufacturing industry is a capital-intensive industry. To build a paper manufacturing factory, every 10,000 tons of paper production capacity requires about 14 million dollars of investment. For a typical paper factory, the industry standard can reach hundreds of thousands of tonnage, resulting in a total investment of several hundreds of millions of dollars. This is why the paper manufacturing industry needs large amounts of capital.

Now let’s use the five forces model to check the paper manufacturing industry’s overall environment. 

First, we are going to look at two things, the competitiveness of the industry and the threat of new entrants. The threat of substitute products will be discussed later.

Now let’s look at this graph, which describes how the paper manufacturing industry progresses in the past 60 years in China. From this graph, we can see that the output is relatively stable from 1950 to 1990, but starts to climb really fast from 1990 to 2008, especially between 2000 and 2008. After 2008, the growth rate starts to slow down.

Even though this graph is about output in the paper manufacturing industry, it actually also shows a similar trend of investment into the industry for the reason that output comes from additional investment. So investment in the paper manufacturing industry is really hot between 1990 and 2010.

But why is there a turning point in 2008?

Well in 2008, Chinese paper manufacturing entered the phase of excess capacity. Excess capacity happens when the production capacity of the industry exceeds its demands, and when it happenss, the competition will be brutal.

Now let’s take a look at this table. The table lists the cost structure of raw materials and labor to produce one ton of paper in different area in the world. 

Producing one ton of paper in different areas across the world can have drastically different costs. In some areas, raw materials are relatively more expensive, and labors in some others. Remarkably, China is a rare exception. We can see that the labor cost in China is really low; but this is consistent with our commonsense – China is still developing and labor costs are relatively low compared with other developed countries. However, raw material cost is really high in China, or about three to four times the price of those of other developed countries. 

Why is that?

Well we mentioned which raw materials the paper manufacturing industry need. First of all, we need wood. Forest resources in China are relatively scarce compared to a lot of countries. For example, the forest coverage rate in certain countries can reach 80%. But in China, it’s less than 30%. Because of this, the Chinese paper manufactory companies have to import wood pulp from other countries.

On the other hand, companies also try to use some substitute materials, such as non-wood plants, or straw pulp. However, producing straw pulp is a serious cause for pollution, and the government has put down serious restrictions on such method. Another source is recycled papers. Since recycled paper are from waste paper, and the paper manufacturers in China have to rely on waste paper import from other developed countries, which will inevitably increase prices. 

Knowing all these, we can come to the conclusion that Chinese paper manufactories have to face suppliers with stronger bargaining power. For a really long period, competition in the industry wasn’t intense. However, it lacks bargaining power against its suppliers, or its upstream.

Household Appliance Industry

The household appliance industry refers to house appliance manufacturers for things like TV, air conditioner, or washing machine, etc. It is one of the first industries to enter into intense competition in China. As competition becomes more and more fierce, we can imgaine that profit margins will become lower and lower. Therefore, the household appliance industry possesses relatively weak bargaining power against its buyers.

Another feature for the Chinese household appliance industry is that for a very long time, the industry has a really specialized sales channel. This channel is centralized under two or three companies’ control, aka. a high market concentration. This gives buyers even stronger bargaining power. Therefore, the household appliance industry is very different from the paper manufacturing industry, as it lacks bargaining power against its buyers, or downstream.

These are the basic conditions of the paper manufacturing industry and the household appliance industry. Understanding this, we will further explore how companies in these two industries perform financially.

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We already learned how to make basic financial analysis. However, financial analysis is only a means to an end; what we want to do is to apply the basic financial analysis to the process of our decision making. 

Before getting into this, let’s think about another question: why do financial data demonstrate differently across different countries and different industries? 

We can easily realize that it is because the environment where the businesses reside will affect each business’ decision-making. And these decisions further affect its final performance.

If we think about how we make decisions, we will find the most important factor affecting our decisions is the environment we are in. This environment could be the whole world’s economic development, or it could be the economic situation of the country. We know that the economic developments in the world are drastically different from one another, and different industries are different as well. 

For example, for companies within the same industry, what competition are they facing? What kind of customers are they dealing with? Is their supply of raw materials in shortage or surplus? Where do their workforces come from? Where does the capital come from? How is their tax situation? Are there any special governmental restrictions? All of these things will influence an enterprise’s decision-making.

But, obviously, given the same environment, not all the enterprises will make the same decisions. For example, within the same country, the same industry, and even the same region, companies face similar environments. But we don’t see all companies doing the same thing. Why? It is because every company makes its own strategic choice. This strategy may include whether it wants to have a diversified business or to focus on only one area. It could also include how the company wants to compete with competitors on every business line. Because of this, companies vary widely even if they are in the same environment.

Let’s dig a step deeper. Within the same industry, the same region, and a similar environment, we can find two companies which adopt similar strategies. However, when we come back to check these two companies a couple of years later, we may find that one company succeeded while the other failed. We see this happening all around the world. 

Why does it happen all the time? Well, even though the two companies choose the same strategy, their abilities to execute that strategy are not the same. Their differences in execution capabilities make the final difference.

This makes companies across the world differ. The differences are caused by at least three levels of factors: the first level is the external environment; the second level is the strategic positioning; and the last level is the strategic execution.

We’ve already known that environments can make big differences in a company’s performance. However, let’s not go all the way into the macros such as worldwide economy or even the macroeconomic development of a certain country. Let’s focus on environment on the industry level first. After that, we can take a look at how strategy positioning affects a company’s financial data. And last, strategic execution.

Porter’s Five Forces

To demonstrate how industry factors affect a company’s financial data, we need to first learn, in this industry as a whole, which factors are crucial for the company’s operations. 

Here we will use a famous model called Porter’s Five Forces, created by the Harvard Business School’s Michael Porter. In any industry, five forces determine an industry’s profitability. 

Existing and Potential Competitions

Let’s look at the three forces at the top. 

The first is the competitive rivalry within an industry. The second is if there are new entrants threatening the industry. The last is if there are threats of substitute products or services in the industry. All three forces will create immense competition to industry incumbents.

Competitors may enter the industry in different ways. So, what will be the impact of intense competition on the company’s financial data?

We can think in this way. As we know, when competition we are facing becomes more and more intense, our company’s profit might get competed out. For example, when originally only our company was selling a specific product, our customers don’t even have another company to compare prices, leaving much more pricing power to us. However, as more and more companies enter the field with similar products, acquiring customers become more and more competitive. We will have to lower the price in order to sell more products. 

After dropping the price, will my cost of goods sold decrease proportionally? 

The truth is, not really. Why? 

Because among our costs, some of them are non-flexible, meaning that costs will not decrease with the decrease of the price at the same rate. In other words, at certain stages, you will find that your cost will basically stop changing, although prices may continue to decrease with intensified competition. As a result, the first thing to drop will be gross profit.

In general, gross profit is the most sensitive factor to changes in the external environment.

Bargaining Powers of Buyers and Suppliers

Now let’s move on to the bottom half of the Five Forces, which are bargaining powers of buyers and suppliers. Normally, Buyers are called downstream because they purchase products from us, and suppliers are called upstream because we purchase products from them. In other words, it indicates the situation of the industrial chain where our company is involved. 

Let’s assume that our industry has really intense competition, and many companies are selling the same product. To acquire customers, not only do we have to ower our prices, but we also need to offer customers credits, i.e. grant them longer payment terms. This is where accounts receivables come in. Of course, if I don’t want to grant credits to customers, I probably will have to suffer longer inventory holding period. 

What determines who is in a stronger position, us or the customers?

It is related to how intense the competition is in my product’s market. The more intense competition my product is facing, the stronger bargaining power my customers have. The bargaining power not only brings them lower prices but also lets them hold my cash longer. Therefore, I will get more accounts receivable. Of course, from another aspect, the bargaining power between my customers and I may also be determined by how many customers I have. We can imagine the situations that I have only one customer versus that I have thousands of customers. The situations are very different. When I have thousands of customers, I will have more choices. If one customer threatens to stop buying my product, I can tell him to EFF OFF. But if I only have one customer, which means that my entire business relies on him, he will get strong bargaining power against me – he probably can do whatever he wants to do then. So customers’ bargaining power is not only determined by the competition in my product’s market but also related to the level of concentration of my customers.

Now let’s have a look at our upstream – the suppliers. One would assume that as a customer, you would always have more power over your supplier. 

But not so fast. Let’s look at what determines who is in a stronger position between a supplier and the company.

Similar to the relationship between our customer and our company, if my raw material market is a market where demand exceeds supply, it will be difficult to purchase the goods. For example, a company that commands over Microsoft, Google, Meta, and OpenAI these days is Nvidia, which is a supplier to all of them. How could some of the most valuable and powerful companies in the world bow down to Nvidia? Well, there is one thing that every single one of them trying to secure from Nvidia: their powerful chips. As all these companies are marching into the AI war, they all want to most powerful GPU chips from Nvidia. And there is no other company that can manufacture anything close to what Nvidia provides.

At this time, we can tell that a supplier such as Nvidia is going to have really strong power. What will he do when he gets to this strong position? He may raise the price, which will increase my costs. Depending on the competitiveness of my market, I may or may not be able to raise prices for my products, and if I don’t, my gross profit ratio will decrease. 

On top of raising prices, a powerful supplier can also make other moves. He may not grant our company any credit on purchase, and may require cash payment to buy goods. He may even demand advance payment and send us the supplies later, occupying the cash that is supposed to be on our bank account for a couple of months. 

Similar to the customers’ bargaininig power, suppliers’ bargaining power is also determined by the demand and supply relation of my raw material market and how many suppliers I have, i.e. the level of concentration of my suppliersw. If I only have one supplier, I will be afraid of losing the supplier, which puts the supplier in a stronger position. On the contrary, if I have thousands of suppliers, I can always buy from someone else should one supplier makes excessive demands. 

Next, we are going to pick two completely different industries to see how the competitiveness affect financials.

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} #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedContent ol ol ol, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-successBody .ml-form-successContent ol ol ol { list-style-type: lower-roman; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedContent p a, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-successBody .ml-form-successContent p a { color: #000000; text-decoration: underline; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-block-form .ml-field-group { text-align: left!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-block-form .ml-field-group label { margin-bottom: 5px; color: #333333; font-size: 14px; font-family: ‘Open Sans’, Arial, Helvetica, sans-serif; font-weight: bold; font-style: normal; text-decoration: none;; display: inline-block; line-height: 20px; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedContent p:last-child, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-successBody .ml-form-successContent p:last-child { margin: 0; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody form { margin: 0; width: 100%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-formContent, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow { margin: 0 0 20px 0; width: 100%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow { float: left; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-formContent.horozintalForm { margin: 0; padding: 0 0 20px 0; width: 100%; height: auto; float: left; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow { margin: 0 0 10px 0; width: 100%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow.ml-last-item { margin: 0; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow.ml-formfieldHorizintal { margin: 0; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input { background-color: #ffffff !important; color: #333333 !important; border-color: #cccccc; border-radius: 4px !important; border-style: solid !important; border-width: 1px !important; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px !important; height: auto; line-height: 21px !important; margin-bottom: 0; margin-top: 0; margin-left: 0; margin-right: 0; padding: 10px 10px !important; width: 100% !important; box-sizing: border-box !important; max-width: 100% !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input::-webkit-input-placeholder, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow input::-webkit-input-placeholder { color: #333333; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input::-moz-placeholder, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow input::-moz-placeholder { color: #333333; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input:-ms-input-placeholder, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow input:-ms-input-placeholder { color: #333333; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input:-moz-placeholder, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow input:-moz-placeholder { color: #333333; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow textarea, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow textarea { background-color: #ffffff !important; color: #333333 !important; border-color: #cccccc; border-radius: 4px !important; border-style: solid !important; border-width: 1px !important; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px !important; height: auto; line-height: 21px !important; margin-bottom: 0; margin-top: 0; padding: 10px 10px !important; width: 100% !important; box-sizing: border-box !important; max-width: 100% !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before { border-color: #cccccc!important; background-color: #ffffff!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input.custom-control-input[type=”checkbox”]{ box-sizing: border-box; padding: 0; position: absolute; z-index: -1; opacity: 0; margin-top: 5px; margin-left: -1.5rem; overflow: visible; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before { border-radius: 4px!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow input[type=checkbox]:checked~.label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox input[type=checkbox]:checked~.label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-input:checked~.custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-input:checked~.custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox input[type=checkbox]:checked~.label-description::after { background-image: url(“data:image/svg+xml,%3csvg xmlns=’http://www.w3.org/2000/svg’ viewBox=’0 0 8 8’%3e%3cpath fill=’%23fff’ d=’M6.564.75l-3.59 3.612-1.538-1.55L0 4.26 2.974 7.25 8 2.193z’/%3e%3c/svg%3e”); } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input:checked~.custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input:checked~.custom-control-label::after { background-image: url(“data:image/svg+xml,%3csvg xmlns=’http://www.w3.org/2000/svg’ viewBox=’-4 -4 8 8’%3e%3ccircle r=’3′ fill=’%23fff’/%3e%3c/svg%3e”); } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox input[type=checkbox]:checked~.label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox input[type=checkbox]:checked~.label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow input[type=checkbox]:checked~.label-description::before { border-color: #000000!important; background-color: #000000!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::after { top: 2px; box-sizing: border-box; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { top: 0px!important; box-sizing: border-box!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { top: 0px!important; box-sizing: border-box!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::after { top: 0px!important; box-sizing: border-box!important; position: absolute; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before { top: 0px!important; box-sizing: border-box!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-control-label::before { position: absolute; top: 4px; left: -1.5rem; display: block; width: 16px; height: 16px; pointer-events: none; content: “”; background-color: #ffffff; border: #adb5bd solid 1px; border-radius: 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-control-label::after { position: absolute; top: 2px!important; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before { position: absolute; top: 4px; left: -1.5rem; display: block; width: 16px; height: 16px; pointer-events: none; content: “”; background-color: #ffffff; border: #adb5bd solid 1px; border-radius: 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::after { position: absolute; top: 0px!important; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { position: absolute; top: 0px!important; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-radio .custom-control-label::after { background: no-repeat 50%/50% 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-checkbox .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { background: no-repeat 50%/50% 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-control, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-control { position: relative; display: block; min-height: 1.5rem; padding-left: 1.5rem; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-input, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-input, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-input { position: absolute; z-index: -1; opacity: 0; box-sizing: border-box; padding: 0; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label { color: #000000; font-size: 12px!important; font-family: ‘Open Sans’, Arial, Helvetica, sans-serif; line-height: 22px; margin-bottom: 0; position: relative; vertical-align: top; font-style: normal; font-weight: 700; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-select, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-select { background-color: #ffffff !important; color: #333333 !important; border-color: #cccccc; border-radius: 4px !important; border-style: solid !important; border-width: 1px !important; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px !important; line-height: 20px !important; margin-bottom: 0; margin-top: 0; padding: 10px 28px 10px 12px !important; width: 100% !important; box-sizing: border-box !important; max-width: 100% !important; height: auto; display: inline-block; vertical-align: middle; background: url(‘https://assets.mlcdn.com/ml/images/default/dropdown.svg’) no-repeat right .75rem center/8px 10px; -webkit-appearance: none; -moz-appearance: none; appearance: none; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow { height: auto; width: 100%; float: left; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-input-horizontal { width: 70%; float: left; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-button-horizontal { width: 30%; float: left; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-button-horizontal.labelsOn { padding-top: 25px; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .horizontal-fields { box-sizing: border-box; float: left; padding-right: 10px; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow input { background-color: #ffffff; color: #333333; border-color: #cccccc; border-radius: 4px; border-style: solid; border-width: 1px; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px; 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In the previous episode, we looked at a company’s capacity to repay short term debts. Next let’s look at how to evaluate a company’s capacity to repay long term debts. 

If you recall, we measure the capacity to pay back short term debts by dividing current assets by current liabilities. In this sense, it seems plausible that we should divide long term asset by long term liabilities to measure the capacity to repay long term debts. 

Wrong. Big time wrong.

When we do calculate the capacity to pay back short term debts, we assume that all our current assets will turn into cash instantly, i.e. getting liquidated, so we can pay with such cash from the current assets after liquidation. 

But if we do the same for long term debts, what would happen? 

Long-term assets consist of non-current assets such as fixed assets, intangible assets, and long-term investments, etc. If we cash out long-term assets, meaning that we will sell all subsidiary companies, manufacturing plants, properties and equipment, etc., do you consider this an act to pay back long-term debt? 

Not at all. The company is about to close doors and cease operations. So the assumption is wrong.

Long-term Solvency

Long-term liabilities usually consist of two parts: one is interest payment and the other one is principal payment. Let’s talk about interest payment first.

Long-term debt interest repayment

How will the company pay interest to its debt? Naturally, you may considering paying back the bank from money we earn, which is net profit of the company. It seems that we should divide the net profit by interests to see if profit can cover interest.

However, this ratio will not be found anywhere. If you recall on the income statement, there is one item called financial expenses which refer to interest payment. In other words, bank interests are actually paid BEFORE we get to net profit. If we use the above method of dividing net profit by interests, we will have paid the interest twice, which doesn’t make any sense.

Which number should we use then? We’ve already understood that we should use the number before we pay the interests, so let’s start from there. 

Since we know the net profit, it is easy to understand that net profit plus interest is the money I earn before paying the interests. However, there is one more thing – income tax. If we look at the income statement, we know that it is after we deduct the financial expense that we deduct income tax. If the company pays a lot interest, it may have no profit for income tax deduction. As a result, it may NOT need to pay for the tax anymore.

By now we are ready to come up with the result for evaluating a company’s ability to repay long-term debt interest. We can use profit before deducting interests and income tax, or earnings before interest and taxes (EBIT) as the basis. 

But we shouldn’t stop there. Remember that we start out to find the ratio to evaluate a company’s ability to repay long-term debt interest. 

Therefore, what we want to do is to divide EBIT by interests to get interest coverage ratio. 

What interest coverage ratio stands for is the number of times that we can pay interests with EBIT. The higher the ratio, the more capable we can pay for the interests. 

If we look at our fictional company, Its net profit is 5.2 million dollars, income tax 1 million dollars, and financial expense 1.3 million dollars. 

Normally if we are unsure about the interest expenses, we can use financial expense as its substitute. By combining 5.2 million, 1 million, and 1.3 million, we got our EBIT value at 7.5 million dollars. If we divide EBIT by interests, which is 1.3 million dollars, we will get an interest coverage ratio of 5.8. This means what the company earns can pay interests 5.8 times. In this sense, it has strong capacity of interest payment. 

Long-term debt principal repayment

Now let’s look at a company’s ability to pay principal. 

The payment of principal is a long term incremental process, and we won’t have a special fund set up just for the long term debt principal payment. Therefore, the measurement of the ability won’t be accurate. 

In reality, there are different ways for such evaluation but none of them are accurate. Here I would like to introduce a very rudimentary method called debt asset ratio, which is dividing total liabilities by total assets.

We can see that we are using not just long term liability but the total liability. Why can debt asset ratio help us measure our ability to repay debt principals? 

The concept is fairly simple and intuitive actually. The more I borrow, the less likely I can pay for it. This ratio is quite useful in reality, and it has another name called financial leverage. 

The reason we call debt asset ratio the financial leverage is that similar to how an actual leverage, it has a magnifying effect. It magnifies the fund of a company. Now what I mean by that?

If a shareholder of a company has 1 million dollars and invests that into the company without borrowing anything, that 1 million dollars will be all he has to invest and thus generate more money from business operations. However, if he borrows another 1 million dollars, he can earn money with two millions dollars instead of one. From the perspective of the shareholder, he would definitely hope that the leverage can be higher. The best scenario is that he doesn’t need to use his own money at all, and all 100% of funding comes from banks. Of course this will never happen in reality, but you get the idea.

So financial leverage is the result of compromise between the two sides, i.e. shareholders and creditors, and the result won’t be too high or too low, but somewhere in the middle. It will vary for different industries; for example, asset intensive industry will likely have higher financial leverage because companies in this industry need a large amount of money to purchase lands and fixed assets, etc. They also have larger asset base to put up as mortgage, giving them stronger borrowing powers. One such example is the airline companies. It is common that many airline companies havea debt ratio of over 80%. 

What type of companies have lower ratios? Normally companies with sufficient cash flow because they don’t need to borrow lots of money. For instance, some distribution companies and asset-light companies, etc.

If we calculate the debt asset ratio of the fictional company, we can see that total asset is 99.2 million, and total liability is 63 million. By dividing 63 million by 99.2 million will get a debt ratio of 63.5%. Of course you can argue that the company doesn’t actually have long term debt at all, so our method might be inaccurate for measuring the ability to pay long term debt. This is a very good question; however, for the time being, this is still an imperfect but valid method to evaluate the company’s overall ability to repay debts.

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By now we have covered common size analysis, profitability analysis, asset turnover ratios, short-term solvency analysis, and long-term solvency analysis. Because cash flow analysis has different issues from the other types of analyses, we will leave it to the last session. If you want to have a full picture recap of all the terminologies we have covered, you can find them here.

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We’ve already covered how to analyze the effectiveness and efficiency of a business, which when combined, will help us evaluate the overall return on investment of a company. However, knowing ROI of a company is not enough. Even though we want to make money from our investment into a company, we definitely don’t want to lose money. 

And the prerequisite of not losing money is that the company must sustain its business operations, i.e. it must have the ability to pay back its debt.

In this episode, let’s look at how to evaluate a company’s ability to deal with liabilities.

If you recall on balance sheet, all liabilities are divided into two parts: current liabilities and non-current liabilities. Current liabilities refer to those debts to be repaid within one year, and non-current liabilities refer to those longer than one year. 

In a similar fashion, we will also categorize the ability to pay back debts into current (or short term) and non-current (or long term). Let’s first look at the ability to pay back short term debt.

Short term debt repayment capacity

The capacity to repay short term debt measures a company’s ability to deal with current liabilities. 

What do current liabilities consist of?

For instance,we may need to pay suppliers money, or accounts payable. If we want to pay suppliers, what is the most appropriate source of money, other than cash?

We won’t be able to apply for a new loan from the bank to pay the suppliers, as it will take too much time. 

If I tell the supplier that I will invest in a project and pay him after the project earns money, he definitely won’t wait.

So where should the payment come from?

If I have cash in hand, that would be perfect. But if I don’t have cash, what I can do is to look at assets that can be easily converted into cash. For example, I can sell products in inventory and collect accounts receivables, both of which are current assets. In fact, for paying suppliers, the most common cash flow comes from current assets.

Let’s make the most optimistic assumption. Let’s assume that all current assets can turn into cash instantly. The amount of potential cash I can use will be the total of all current assets. By dividing current assets by current liabilities, we can get a measure called current ratio to help us evaluate a company’s short-term debt repayment capacity. The higher the ratio, the stronger its ability to repay current liabilities.

Yet this calculation method is based on a very optimistic assumption, i.e. all current assets can turn into cash instantaneously. In reality though, this is impossible. So we need a more conservative and realistic method.

Amongst all current assets, the slowest asset that can be turned into cash is inventory. The reason is that we will need to first sell inventory and acquire accounts receivables, which will become cash upon collection. If we use the most conservative estimation that NO inventory will become cash at all, we should deduct all inventory from current assets before dividing it with current liabilities. The result is a more conservative estimation of a company’s capacity to repay short-term debt called quick ratio.

Let’s work on an example of current ratio and quick ratio of our fictional company. 

The company’s current assets are 40.7 million dollars, and its current liabilities are 63 million dollars. By dividing the former by the latter, we will get the current ratio of 0.65. 

The quick ratio should be calculated after deducting inventory from current assets. Since the company’s inventory is 5 million, the result will be 35.7 million after the deduction, making the quick ratio at 0.57.

Making sense of current ratio and quick ratio

Now that we’ve already understood how to calculate current ratio and quick ratio, how do we make sense of them, i.e. what kind of current ratio and quick ratio would be acceptable, safe, and desirable for a company?

If the current ratio of a company is 1, would that company be in danger of insolvency? How is its capability to pay back short term liabilities?

We’ve already mentioned that the current ratio is based on the most optimistic assumption that all current assets can be converted into cash instantaneously. However, that’s simply not the case in reality. If, for example, we are desperate to sell our products in order to repay debt, we will almost definitely need to apply a discount. Besides, some account receivables may never be collected. Therefore, if the current ratio is 1, we may actually be in danger. 

Despite all the above issues, there could be another problem if the current ratio is 1: even if all current assets become cash instantly to cover all current liabilities, there won’t be any cash or inventory left for future operations. The company will still need to file for bankruptcy. 

Current assets have two roles in a company’s operations. One is to cover current liabilities repayment, and the other is to provide fund for daily operations. 

It seems that a current ratio of 1 is not enough. But what about 2? 

If you’ve encountered certain accounting books, some of them might have mentioned that a current ratio of 2 would be ideal. It certainly sounds legit: since the roles of current assets are to repay current debts and sustain daily operations, having twice the amount of current liabilities as current assets certainly sounds safe.

But is it the case? Let’s look at a graph. 

In this graph, the y-axis represents current ratio, and the x-axis represents number of years before bankruptcy. The line at the top of the graph represents healthy companies, while the line at the bottom represents bankrupt companies. From this graph, we can see that the current ratios of healthy companies are always higher than those of bankrupt companies, regardless of which year. 

In addition, the average of bankrupt companies is actually around 2, even for the year before their actual bankruptcy! This directly contradicts what books have told us. So if you believe in this number and operate your company accordingly, you may make lots of mistakes and put your company on the line.

Then can we conclude that having a current ratio of 3 or 4 would be ideal? 

Well if you are operating a business in the United States, that would certainly be the case, as this graph is based on data within the country. However, if you are operating in other countries such as China, you might be too conservative. Let me tell you why.

In China , even current ratios of most healthy companies are between 1 and 2, lower than those of bankrupt companies in the US. This is because banks in China don’t grant long-term loans, but they extend short-term loans multiple times, which are essentially the same as long-term loans. In other words, the source of funds to pay off current liabilities is not current assets, but new current liabilities. Under such a model, companies won’t face serious problems even with relatively low current ratios.

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Return on Investment is dependent on two things: effectiveness and efficiency. To measure effectiveness, we can use gross profit ratio and net profit ratio. To measure efficiency, we can use total assets turnover. Now we will talk a little bit more about the total assets turnover. 

Turnover is a measure of business operations capacity

Generally speaking, we use turnover as a measure of business operation capacity. We’ve already talked about total asset turnover, but there are different types of assets. As a matter of fact, we can actually calculate turnover for every asset.

Just like how we calculate total assets turnover, which is revenue divided by total assets, we can calculate different asset turnovers by having revenue divided by an asset. This is the turnover ratio for a specific asset.

For example, by using revenue divided by account receivables, we can get accounts receivable turnover, which is a measure of accounts receivable efficiency. Similarly, if we divide revenue with current asset, we can get current asset turnover, which is a measure of current asset efficiency. And revenue divided by fixed assets is called fixed assets turnover.

The only exception is inventory. Even though in theory, revenue divided by inventory is not wrong, but in practice, we generally use another way to calculate inventory turnover, which is using cost of goods sold divided by inventory.

Why is that the case? We have covered that there is a close relationship between inventory and cost of goods sold. After producing a certain product, it becomes inventory. Inventory will NOT become cost of goods sold UNLESS the product is sold. As a result, it makes more sense to calculate inventory turnover by using cost of goods sold instead of revenue.

Duration vs. Point of Time

While calculating turnover ratios, we are always using numbers from the income statement, i.e. revenue or cost of goods sold, as the numerator. However, the denominators are always from the balance sheet. We have mentioned that balance sheet is based on specific time point, but income statement is based on duration. If we use division on these two data, which have different time frames, we might encounter some problems.

Actually, the assumption when we are doing such calculations is that the asset is the annual average. We don’t know for sure if this assumption is accurate; a common method to offset inaccuracy is to use the average of the beginning value and the final value of a specific asset during the period. Same thing goes with inventory and cost of goods sold.

However, doing so would cause another problem. We have previously said that by multiplying effectiveness and efficiency, we will get return on investment. This relationship exists at any points in time. However, when we switch to using average values, this equation may not work. 

After judging the pros and cons of both issues, i.e. the duration vs. point of time issue and the above equation issue, we would normally revert to using a simplified method of using the en-of-the-year value of assets while calculating all financial ratios.

Economic implication of turnovers

Turnovers measure the number of times an asset has circulated in a year. For example, how many times will the asset circulate in a given time period? 

As a result, apparently the turnover unit is the number of times the asset has been circulated in a year. 

If an asset is circled twice a year, we would normally say that the turnover of this asset is 2, and it takes half a year for the asset to make a circulation. So turnover ratio helps us calculate the length of an asset’s circulation.

Let’s calculate the assets turnover using the financial statements of our fictional company. 

Accounts receivable turnover

First, let’s look at the accounts receivable turnover. The way to calculate accounts receivable turnover ratio is to take revenue and divide it by accounts receivable. In this case, our revenue is 43 million dollars and our accounts receivable is 13 million dollars, and accounts receivable turnover ratio is 3.3. In other words, the turnover is 3.3 time a year, which is about less than four months in one circulation. To be more specific, if there are 365 days in a year and turnover is 3.3 times, it means one circulation will take 109 days, i.e. our accounts receivable can be collected every 109 days on average.

Inventory turnover

What about inventory turnover? We’ve already covered that inventory turnover is cost of goods sold divided by inventory. For our fictional company, the cost of goods sold is 31 million dollars a year, and the inventory is 5 million. By dividing 31 million with 5 million, we will get 6.2, which means the company’s inventory circles 6.2 times a year. In other words, it takes about 2 month for a specific batch of inventory to finish one circulation. The calculation works like this: by dividing 365 days/year with 6.2, we will get 58 days as the result. This means that on average, the company will need to hold inventory for about 58 days.

For the above example, when does the inventory holding period start and when does it end? How do we actually make sense of the 58 days? 

We know inventories include raw material, product-in-process, and finished goods. Inventory holding period is defined as starting from the purchasing of raw materials to the selling of finished goods, which is a cycle (or circulation). For our fictional company, this cycle takes about 58 days.

When a company makes a sale, part of its inventory (on the balance sheet) will move into cost of goods sold (on the income statement). After making the sale, part of the revenue will be collected as cash, but part of it will become accounts receivable, which later will be collected and become cash. For our fictional company, the inventory holding period is 58 days and the accounts receivable collection period is 109 days, which add up to 167 days in total. What this means is that it will take a little less than half a year to turn cash into materials and back to cash again for the company.

Fixed assets turnover

We can also easily calculate the other assets turnover ratios with this method. For example, the fixed asset turnover is calculated by dividing revenue with fixed assets. For our company, the revenue is 43 million and fixed asset is 57 million, making the fixed assets turnover 0.8. In other words, the circulation of fixed assets will NOT complete in a year. A less than 1 fixed assets turnover is pretty normal, especially for a large manufacturing company. 

Current assets turnover

Similarly, we can calculate the current assets turnover as well. By dividing revenue (43 million) with current assets (40.7 million), we can get our current assets turnover ratio of 1.05, which means that our current assets can finish circulation within a year.

Total assets turnover

Last but not least, we can calculate the total assets turnover. The company’s total assets turnover is revenue divided by total assets; the revenue of the company is 43 million and the total assets is 99.2 million, making the total assets turnover 0.43. 

Return on investment – for who?

Combining all the above turnover ratios, including that of total asset and all other assets, can help paint us a picture of the operation capacity of the company. We said turnover ratio indicates efficiency, which when combined with effectiveness, will determine the return on investment.

Return on investment is one thing that we, as consumers, also encounter every day. For companies, it shows the rate of return on total assets. In other words, it’s the return I can receive after I invest in the total assets. However, if you pay special attention to where all assets are coming from, part of them actually come from resources provided by creditors such as banks. In other words, the resources of total assets are from two parts, one part from creditors, while the other part from stockholders. 

Return on net assets vs. return on total assets

For stockholders, they actually care more about the return on their own investment. Here we come up with another concept: rate of return on net assets, which is calculated as net profit divided by stockholders equity.

The amount stockholders invest in the company is the stockholders’ equity. The return for stockholders’ investment is the company’s net profit. If we take the net profit and divide it by stockholders’ equity, we will get return on investment for the shareholders’ investment in the company.

However, shouldn’t we just call it return on equity instead of return on net assets? 

Well, technically we could, but the conventional practice is to use the latter. The reason is that we can often refer to stockholders’ equity as net assets, since stockholders’ equity equals total assets minus liabilities. That is to say, the net value of the company actually belongs to the stockholders. 

Now let’s calculate the return on investment for total assets and net assets and see what we get.

First of all, let’s look at the return on total assets. Return on total assets is calculated as net profit divided by total assets. The company has a net profit of 5.2 million this year and its total assets are 99.2 million. After dividing the former by the latter, we get the return on total assets at around 5%.

Next, let’s work on its return on net assets. The net profit of the company is 5.2 million and the stockholders’ equity is 36.2 million. After doing the same calculation, we arrive at the company’s return on net assets at about 14%.

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font-size: 14px !important; height: auto; line-height: 21px !important; margin-bottom: 0; margin-top: 0; padding: 10px 10px !important; width: 100% !important; box-sizing: border-box !important; max-width: 100% !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before { border-color: #cccccc!important; background-color: #ffffff!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow input.custom-control-input[type=”checkbox”]{ box-sizing: border-box; padding: 0; position: absolute; z-index: -1; opacity: 0; margin-top: 5px; margin-left: -1.5rem; overflow: visible; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before { border-radius: 4px!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow input[type=checkbox]:checked~.label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox input[type=checkbox]:checked~.label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-input:checked~.custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-input:checked~.custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox input[type=checkbox]:checked~.label-description::after { background-image: url(“data:image/svg+xml,%3csvg xmlns=’http://www.w3.org/2000/svg’ viewBox=’0 0 8 8’%3e%3cpath fill=’%23fff’ d=’M6.564.75l-3.59 3.612-1.538-1.55L0 4.26 2.974 7.25 8 2.193z’/%3e%3c/svg%3e”); } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input:checked~.custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input:checked~.custom-control-label::after { background-image: url(“data:image/svg+xml,%3csvg xmlns=’http://www.w3.org/2000/svg’ viewBox=’-4 -4 8 8’%3e%3ccircle r=’3′ fill=’%23fff’/%3e%3c/svg%3e”); } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-input:checked~.custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox input[type=checkbox]:checked~.label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox input[type=checkbox]:checked~.label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow input[type=checkbox]:checked~.label-description::before { border-color: #000000!important; background-color: #000000!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label::after { top: 2px; box-sizing: border-box; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { top: 0px!important; box-sizing: border-box!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { top: 0px!important; box-sizing: border-box!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::after { top: 0px!important; box-sizing: border-box!important; position: absolute; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before { top: 0px!important; box-sizing: border-box!important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-control-label::before { position: absolute; top: 4px; left: -1.5rem; display: block; width: 16px; height: 16px; pointer-events: none; content: “”; background-color: #ffffff; border: #adb5bd solid 1px; border-radius: 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-control-label::after { position: absolute; top: 2px!important; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::before, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::before { position: absolute; top: 4px; left: -1.5rem; display: block; width: 16px; height: 16px; pointer-events: none; content: “”; background-color: #ffffff; border: #adb5bd solid 1px; border-radius: 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::after { position: absolute; top: 0px!important; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { position: absolute; top: 0px!important; left: -1.5rem; display: block; width: 1rem; height: 1rem; content: “”; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-radio .custom-control-label::after { background: no-repeat 50%/50% 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .custom-checkbox .custom-control-label::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedPermissions .ml-form-embedPermissionsOptionsCheckbox .label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-interestGroupsRow .ml-form-interestGroupsRowCheckbox .label-description::after, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description::after { background: no-repeat 50%/50% 50%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-control, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-control { position: relative; display: block; min-height: 1.5rem; padding-left: 1.5rem; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-input, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-input, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-input, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-input { position: absolute; z-index: -1; opacity: 0; box-sizing: border-box; padding: 0; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-radio .custom-control-label, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-radio .custom-control-label, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-checkbox .custom-control-label, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-checkbox .custom-control-label { color: #000000; font-size: 12px!important; font-family: ‘Open Sans’, Arial, Helvetica, sans-serif; line-height: 22px; margin-bottom: 0; position: relative; vertical-align: top; font-style: normal; font-weight: 700; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-fieldRow .custom-select, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow .custom-select { background-color: #ffffff !important; color: #333333 !important; border-color: #cccccc; border-radius: 4px !important; border-style: solid !important; border-width: 1px !important; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px !important; line-height: 20px !important; margin-bottom: 0; margin-top: 0; padding: 10px 28px 10px 12px !important; width: 100% !important; box-sizing: border-box !important; max-width: 100% !important; height: auto; display: inline-block; vertical-align: middle; background: url(‘https://assets.mlcdn.com/ml/images/default/dropdown.svg’) no-repeat right .75rem center/8px 10px; -webkit-appearance: none; -moz-appearance: none; appearance: none; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow { height: auto; width: 100%; float: left; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-input-horizontal { width: 70%; float: left; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-button-horizontal { width: 30%; float: left; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-button-horizontal.labelsOn { padding-top: 25px; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .horizontal-fields { box-sizing: border-box; float: left; padding-right: 10px; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow input { background-color: #ffffff; color: #333333; border-color: #cccccc; border-radius: 4px; border-style: solid; border-width: 1px; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px; line-height: 20px; margin-bottom: 0; margin-top: 0; padding: 10px 10px; width: 100%; box-sizing: border-box; overflow-y: initial; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow button { background-color: #000000 !important; border-color: #000000; border-style: solid; border-width: 1px; border-radius: 4px; box-shadow: none; color: #ffffff !important; cursor: pointer; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif; font-size: 14px !important; font-weight: 700; line-height: 20px; margin: 0 !important; padding: 10px !important; width: 100%; height: auto; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-horizontalRow button:hover { background-color: #1F5014 !important; border-color: #1F5014 !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow input[type=”checkbox”] { box-sizing: border-box; padding: 0; position: absolute; z-index: -1; opacity: 0; margin-top: 5px; margin-left: -1.5rem; overflow: visible; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow .label-description { color: #000000; display: block; font-family: ‘Open Sans’, Arial, Helvetica, sans-serif; font-size: 12px; text-align: left; margin-bottom: 0; position: relative; vertical-align: top; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow label { font-weight: normal; margin: 0; padding: 0; position: relative; display: block; min-height: 24px; padding-left: 24px; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow label a { color: #000000; text-decoration: underline; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow label p { color: #000000 !important; font-family: ‘Open Sans’, Arial, Helvetica, sans-serif !important; font-size: 12px !important; font-weight: normal !important; line-height: 18px !important; padding: 0 !important; margin: 0 5px 0 0 !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow label p:last-child { margin: 0; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedSubmit { margin: 0 0 20px 0; float: left; width: 100%; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedSubmit button { background-color: #000000 !important; border: none !important; border-radius: 4px !important; box-shadow: none !important; color: #ffffff !important; cursor: pointer; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif !important; font-size: 14px !important; font-weight: 700 !important; line-height: 21px !important; height: auto; padding: 10px !important; width: 100% !important; box-sizing: border-box !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedSubmit button.loading { display: none; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-embedSubmit button:hover { background-color: #1F5014 !important; } .ml-subscribe-close { width: 30px; height: 30px; background: url(‘https://assets.mlcdn.com/ml/images/default/modal_close.png’) no-repeat; background-size: 30px; cursor: pointer; margin-top: -10px; margin-right: -10px; position: absolute; top: 0; right: 0; } .ml-error input, .ml-error textarea, .ml-error select { border-color: red!important; } .ml-error .custom-checkbox-radio-list { border: 1px solid red !important; border-radius: 4px; padding: 10px; } .ml-error .label-description, .ml-error .label-description p, .ml-error .label-description p a, .ml-error label:first-child { color: #ff0000 !important; } #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow.ml-error .label-description p, #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-checkboxRow.ml-error .label-description p:first-letter { color: #ff0000 !important; } @media only screen and (max-width: 400px){ .ml-form-embedWrapper.embedDefault, .ml-form-embedWrapper.embedPopup { width: 100%!important; } .ml-form-formContent.horozintalForm { float: left!important; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow { height: auto!important; width: 100%!important; float: left!important; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-input-horizontal { width: 100%!important; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-input-horizontal > div { padding-right: 0px!important; padding-bottom: 10px; } .ml-form-formContent.horozintalForm .ml-button-horizontal { width: 100%!important; } .ml-form-formContent.horozintalForm .ml-button-horizontal.labelsOn { padding-top: 0px!important; } } .ml-mobileButton-horizontal { display: none; } #mlb2-14362251 .ml-mobileButton-horizontal button { background-color: #000000 !important; border-color: #000000 !important; border-style: solid !important; border-width: 1px !important; border-radius: 4px !important; box-shadow: none !important; color: #ffffff !important; cursor: pointer; font-family: ‘Lucida Sans Unicode’, ‘Lucida Grande’, sans-serif !important; font-size: 14px !important; font-weight: 700 !important; line-height: 20px !important; padding: 10px !important; width: 100% !important; } @media only screen and (max-width: 400px) { #mlb2-14362251.ml-form-embedContainer .ml-form-embedWrapper .ml-form-embedBody .ml-form-formContent.horozintalForm { padding: 0 0 10px 0 !important; } .ml-hide-horizontal { display: none !important; } .ml-form-formContent.horozintalForm .ml-button-horizontal { display: none!important; } .ml-mobileButton-horizontal { display: inline-block !important; margin-bottom: 20px;width:100%; } .ml-form-formContent.horozintalForm .ml-form-horizontalRow .ml-input-horizontal > div { padding-bottom: 0px !important; } } @media only screen and (max-width: 400px) { .ml-form-formContent.horozintalForm .ml-form-horizontalRow .horizontal-fields { margin-bottom: 10px !important; width: 100% !important; } }

function ml_webform_success_14362251() { var $ = ml_jQuery || jQuery; $(‘.ml-subscribe-form-14362251 .row-success’).show(); $(‘.ml-subscribe-form-14362251 .row-form’).hide(); } fetch(“https://assets.mailerlite.com/jsonp/918262/forms/119753320103413631/takel”)