Accrual Accounting

"It takes money to make money," goes the old saying, and it's true. Even the smallest business uses money to grow. Management effectiveness ratios address the question: how well is a company performing with the money that owners and others have invested in it?

These ratios are widely regarded as the best measure of corporate performance. You can give a firm high marks for posting good profit margins or for turning over its inventory quickly, but the final grade depends on how much profit it generates with the money invested by owners and creditors. Or, to put it another way, that grade depends on the answer to the question: is the company making a sufficiently high return on its assets?

Like management efficiency ratios, management effectiveness ratios examine the relationship between items on the income statement and items on the balance sheet. From the income statement you always need to know the "bottom line" - net profit. The information that you need from the balance sheet varies according to the ratio that you're trying to calculate, but it's always some measure of the amount of capital used in the business. Common measures of capital investment include total equity, total assets, or a combination of equity and long-term debt. Let's see whether The College Shop made the grade. Did it generate a reasonable profit on the assets invested in the company?

$\text{Return on assets} = \dfrac{\text{Net Profit}}{\text{Total assets}}$

Year 1 :  $\dfrac{$30,000}{$360,000}  = 8.3\%$

Year 2:  $\dfrac{$18,000}{$368,000}  = 4.9\%$

Because the industry average return on assets is 7.9 percent, The College Shop gets an "A" for its first year's performance. It slipped in the second year but is probably still in the "B" range.