Return-on-investment ratios compare measures of benefits, such as earnings or net income, with measures of investment. For example, if an investor wants to evaluate how well the firm uses its assets in its operations, he could calculate the return on assets—sometimes called the basic earning power ratio—as the ratio of earnings before interest and taxes (EBIT) (also known as operating earnings) to total assets:

For Fictitious Corporation, for the current year,

For every dollar invested in assets, Fictitious earned about 18 cents in the current year. This measure deals with earnings from operations; it does not consider how these operations are financed.
Another return-on-assets ratio uses net income—operating earnings less interest and taxes—instead of earnings before interest and taxes:
TABLE 3.3 Fictitious Company Statement of Cash Flows, Years Ended December 31 (in thousands)


(In actual application the same term, return on assets, is often used to describe both ratios. It is only in the actual context or through an examination of the numbers themselves that we know which return ratio is presented. We use two different terms to describe these two return-on-asset ratios in this chapter simply to avoid any confusion.)

For Fictitious in the current year:

Thus, without taking into consideration how assets are financed, the return on assets for Fictitious is 18%. Taking into consideration how assets are financed, the return on assets is 11%. The difference is due to Fictitious financing part of its total assets with debt, incurring interest of $400,000 in the current year; hence, the return-on-assets ratio excludes taxes of $400,000 in the current year from earnings in the numerator.
If we look at Fictitious’s liabilities and equities, we see that the assets are financed in part by liabilities ($1 million short term, $4 million long term) and in part by equity ($800,000 preferred stock, $5.2 million common stock). Investors may not be interested in the return the firm gets from its total investment (debt plus equity), but rather shareholders are interested in the return the firm can generate on their investment. The return on equity is the ratio of the net income shareholders receive to their equity in the stock:

For Fictitious Corporation, there is only one type of shareholder: common. For the current year,