Efficiency Ratio Basics for Investment Bankers - dummies

Efficiency Ratio Basics for Investment Bankers

By Matt Krantz, Robert R. Johnson

Most large public companies are not owned by the CEO or the management team. Investment bankers know that large public companies are run using other people’s property, specifically stock and bonds.

But investors don’t entrust money to management lightly and they’re not doing it for fun. Investors are looking to get a return on their invested capital and pay close attention to whether management is delivering adequate returns.

Efficiency ratios can be a very useful way for investors to monitor whether a company’s management team is putting money entrusted to it to good use. CEOs like to talk a big game and say they’re positioning the company well for the future. But the efficiency ratios cut beyond the hot air, something investment bankers must be well prepared to address.

Efficiency ratios not only show if the management is a proper steward to the financial resources entrusted to them, but by how much.

Efficiency ratios are examples of how insights can be gleaned by comparing data from two separate financial statements: the income statement and the balance sheet. Such cross-financial statement analysis can be very insightful when putting a company’s profit into context.

The primary efficiency ratios of most importance to investment bankers include

  • Return on assets: Is that fancy factory the company borrowed money to buy really paying off for investors? Find out using return on assets. Return on assets tells the investment banker how much of a profit is being driven from the company’s fixed investments, such as plant, property, and equipment.

  • Return on capital: Companies may sell stock and they may issue debt. Raising money puts cash into the hands of the management team, which then, presumably, invests that cash in projects that generate returns. But are the returns the management is getting enough to justify the cost of the money they raised? That’s the question investment bankers can answer using return on capital.

  • Return on equity: If there’s anyone who focuses on what kind of return they’re getting, it’s the shareholders. After all, the bondholders know what they’re getting. As long as the company stays in business, and pays its debts, bondholders can collect both the coupon rate (the interest rate the borrower agreed to pay) paid on the bonds the company issued and get the principal amount of the loan back.

    But stockholders don’t receive a payment as certain or concrete as an interest payment. That’s where return on equity comes in. This handy ratio can tell stock investors what kind of return the company is generating on the money entrusted to it.