Maintaining an acceptable return on shareholders’ equity is an important objective for investors, and senior managers are hired to maximize these returns. The Scott formula highlights a number of interconnected ratios and demonstrates how these influence return on shareholders’ equity. Because of this, it can provide a valuable analytic tool for investors and managers.
In BDCC’s case, the formula results indicate that return on shareholders’ equity has declined from 10.7% to 9.4% over the three years (column 5), in spite of increasing returns from leveraging of .1% in 2019 to 1.9% in 2021 (columns 3 and 4). Return on operating capital has declined more precipitously than ROSE, from 10.6% in 2019 to 8.3% in 2021 (columns 1 and 2). With respect to return on operating capital, and as noted earlier, the after-tax operating profit ratio displays no trend (column 1). However, the sales to operating capital ratio has declined from 2.2 times in 2019 to 1.6 times in 2020 and 2021, indicating that the additions to operating assets as yet have not been matched with a proportionate increase in sales. With respect to return on leverage, the relatively small difference between return on capital and the after-tax cost of borrowing funds in 2020 and 2021 (column 3) suggests that return from leveraging will most likely be improved by increasing the difference between return on capital and the after-tax cost of borrowing funds. This further emphasizes the importance of increasing the sales to operating capital ratio, as it most significantly affects the return on operating capital ratio. The relatively low debt to shareholders’ equity ratio (column 4), suggests that BDCC should consider borrowing more funds when required, rather than issuing additional shares and increasing the amount of shareholders’ equity. This can magnify return on leveraging. However, the difference between return on operating capital and the cost of borrowed funds should be improved before more borrowing takes place, to minimize risk to shareholders and maximize effects on return on shareholders’ equity.
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