Primary Investment Ratio
The primary investment ratio, also known as operating return on equity, is one of several measurements used in financial analysis. This ratio is used to assess the profitability of businesses, and how well they make use of capital. For example, when investors place their money in a corporation, or consider doing so, the primary investment ratio helps determine if that decision is worthwhile. Since the ratio is implemented when assessing company worth, it is more appropriately applied to businesses in operation for profit.
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Calculation
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To calculate the primary investment ratio a corporation's earnings before interest and tax are divided by total shareholder equity. The first of these numbers is determined by subtracting business expenses from sales revenue, and the second number is the total value of a company's shares. According to James Grant, author of Economic value added, the operating return on equity is also calculated by multiplying a company's return on assets by its leverage, calculated by dividing assets by equity.
Utilization
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Accountants, lenders and investors all have the primary investment ratio available to them when making decisions about a business. Business executives also use this number when reporting periodic financial information about their company. If the primary investment ratio is high, it indicates a business has generated a good level of profit for each dollar of capital invested in the company. If a company has a low primary investment ratio, investors may reconsider where they put their money.
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Advantages
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An important advantage of the primary investment ratio is it allows analysts and lenders to quickly determine if a business has the ability to pay for debt. Additionally, because the ratio does not subtract tax and income from earnings, it provides a better understanding of core corporate ability to generate income. The primary investment ratio also shows how well a company generates income despite tax burdens, and can be used within related formulas that also calculate a company's return on equity.
Disadvantages
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Without comparing the primary investment ratio against the same ratio from previous periods in the business cycle, a comprehensive and chronological financial evaluation cannot be determined according to the University of Notre Dame. Financial ratios can also be manipulated by business decision-making such as stock buybacks that reduce the number of existing shares and increase the primary investment ratio. Another limitation of the ratio is it does not examine the influence of other metrics such as those that measure how well businesses use cash flow.
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