1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Mark Lin
Mark Lin
Articles (212) 

Why Ratios Like Return on Assets and Dividend Payout Are Calculated Wrongly

November 19, 2012 | About:

I get asked two questions on dividend payout very frequently. The first question is why a loss-making company can still pay dividends. The second question is why a company pays so little of its retained earnings.

Both questions are the result of severe misconceptions, partly due to how accounting deals with dividends.

In double-entry accounting, when the company pays out a cash dividend, the retained earnings account is debited and the cash credited, reflecting a reduction in the retained earnings balance and the cash balance. However, the debiting of the retained earnings or accumulated profits balance is an accounting charge. Dividends are, and have to be, paid out from cash.

Going back to answering the first two questions at the start of this article, a loss-making company can still pay dividends as long as it still has cash on the balance sheet. With respect to the second question, retained earnings reflect the accumulation of accounting earnings over time but not necessarily cash-generating ability and cash availability.

It also brings to the table an important fact: The dividend payout ratio has always been and is still calculated wrongly. The denominator in the dividend payout ratio should be free cash flow, instead of accounting earnings.

It is the same issue with the return on assets calculation (ROA). ROA is meant to be differentiated from ROE by the fact that ROA is a pure operating measure independent of financing. The denominator in the ROA calculation should be operating income instead of net income which reflects financing decisions with the deduction of interest expense. In recent years, return on invested capital has been gaining in popularity over ROA and even ROE as a measure of company value creation.

About the author:

Mark Lin

Rating: 3.6/5 (7 votes)


Ry.zamora - 4 years ago    Report SPAM

You'll find that RNOA or "Return on Net Operating Assets" is a more precise measure of returns on operations as it employs operating income (typically adjusted further for taxes). This is typically compared to ROE to determine how much of returns come from operations. From experience, anything above 100% indicates financial leverage is a burden on the company's profitability.

What you should reflect over perhaps is the analysts' metric for efficiency: the asset turnover ratio. That is something calculated wrongly. All I have to do is ask you one thing: at the end of the day, should the concept of "efficiency" be equated to the "ability to generate sales"?

The commonsense answer should be obvious. Blatant, in fact.
Marklin premium member - 4 years ago

Hi Ry.zamora, thanks for your inputs.

I agree with you that RNOA and/or ROIC are better measures of returns. For adjusted measures and ratios like RNOA and ROIC, the recasting of the financial numbers and the definition of operating income and net operating assets/invested capital becomes crucial to the quality of the measure.

As you pointed out correctly, besides ROA and dividend payout, there are many misused and misunderstood ratios and measures out there. However, the fault lies with the user, not the tools. Users of financial statements and ratios have to apply caution and discretion in calculating and interpreting such numbers.

Batbeer2 premium member - 4 years ago
>> However, the fault lies with the user, not the tools. Users of financial statements and ratios have to apply caution and discretion in calculating and interpreting such numbers.


Please leave your comment:

Performances of the stocks mentioned by Mark Lin

User Generated Screeners

alberto.lopezblancoAdquirer's Multiple
HOLKLSUTest First Group Trump Trade
pbarker46Begin here, dividend growth
56748392AJM PEG
charliebatteninside + price
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat