RecognizingSuccess 129on a long-term (over one year) basis. A business may borrow capital
rather than issue equity if it needs capital and believes it will gen-
erate greater returns on the capital than the costs of borrowing it.
Suppose a business with $100 million in shareholder equity bor-
rows $50 million from long-term lenders and then generates earn-
ings of $15 million on that total capital. Its return on investment will
be 10% (15/150). But this leveraging boosts the business’s return on
equity—earnings of $15 million on shareholder equity of $100 mil-
lion means a return on equity of 15%.
Using debt to boost return on equity is common but by no means
imperative. Some companies generate sufficient cash from their op-
erations to enable high returns on equity more cheaply than they
coul dby borrowing. As was note dearlier, Microsoft is debt-free,
generating returns on equity of nearly 34% an dreturns on invest-
ment that are just about the same (a similar near 1:1 ratio holds
across the computer industry).
The norm among the S&P 500 is to use debt, driving the average
return on equity to about 22% while return on investment is about
14%. GE exploits leverage with more spectacular results, with returns
on equity of nearly 27% tripling return on investment of just above
9% (similar results hol dacross the conglomerate sector).
Return on Assets
Return on assets is the amount a business earns on all its re-
sources—not only shareholder equity and long-term borrowing but
short-term resources generate dby effective management of working
capital. A business may seek short-term, low-rate loans or buy goods
on credit that it resells for cash, thus increasing the assets available
for deployment at low or no cost. Those assets contribute to incre-
mental increases in earnings, boosting both return on equity and
return on assets.
Suppose a business maintains an average amount of short-term
assets of $20 million over a year (by continually repaying the obli-
gations as they come due and incurring new ones as rollovers). That
coul dincrease incremental annual earnings by, say, $2 million. Thus,
a company with shareholder equity of $100 million and long-term
debt of $50 million, carrying that additional $20 million in the short
term an dearning $17 million, generates a return on assets of 10%
(17/170). This deployment boosts return on investment to 11.3%
(17/150) an dreturn on equity to 17% (17/100).