| LO3 - Describe the Scott formula and explain how it is used to analyze financial statements. |
The Scott formula was developed by WR Scott, a Canadian accounting academic. The formula links return on total assets (ROA) to return on shareholders’ equity (ROSE), and also integrates a number of related financial ratios to provide a more informed analysis of ROSE. The formula breaks down return on shareholders’ equity into two major components –return on operating capital, similar to return on total assets, and return on leveraging – that is, the return to a corporation through its ability to borrow money at a given interest rate, purchase assets with the loan proceeds, and earn a return on these assets that is greater than the interest rate paid on the loan. This excess return accrues to shareholders since creditors already have been paid for the use of borrowed funds via interest payments.
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