ACCOUNTING TUTORIALS
Part 2: The Basics of Interpreting Financial Statements
Rate of Return
- Allows managers to choose between investment alternatives
Suppose that you are offered a choice between two investments, each of which requires an initial outlay of $2,000. You are told that Investment A will yield a return of $100, and Investment B will yield a return of $120. (Both investments will also return the original $2,000 outlay.) Which is the better investment?
The answer is obvious, and is confirmed by calculating each investment’s rate of return:
- Investment A rate of return = $100 / $2000 = 5%
- Investment B rate of return = $120 / $2000 = 6%
Investment B yields a higher rate of return (6%) so it is clearly the better alternative.
The choice becomes a bit trickier when the amount of the initial outlay varies. Now suppose that you are offered a choice between two more investments:
- Investment C requires an initial outlay of $5,000, and yields a return of $400.
- Investment D requires and initial outlay of $7,500, and yields a return of $700.
It is more difficult to “eyeball” this one. You have to actually calculate the rate of return in order to answer:
- Investment C rate of return = $400 / $5,000 = 8%
- Investment D rate of return = $700 / $7,500 = 9.3%
Per the above calculations, Investment D is the better alternative.