Annualized Rate

  

The factors that go into short-term financial decisions can get so complex that it becomes difficult to compare options. There's just a lot of ins and outs to keep in the ol' duder's head (if you were born after 1984, that's a Big Lebowski reference).

To make these comparisons easier, it is helpful to find a standard period of comparison. That's why most business information gets reported on an annualized basis (See: Annualize). The process of annualization looks at whatever you are comparing as if you were doing that thing for a full year.

This comes up a lot in interest rates. You might take out a short-term loan from a payday lender. Under the terms of the loan, it might cost you $10 to borrow $250 for two weeks. This might not seem like much ("hey, it's just ten bucks"), but if you annualize that rate, it comes out to more than 100%.

By comparison, most credit cards only carry an annual rate in the low 20% range. By annualizing the figures, you can more easily decide that putting that $250 on your credit card makes more sense than taking out the loan.

Related or Semi-related Video

Finance: What are Return on Equity and R...145 Views

00:00

finance a la shmoop. what are return on equity and return on assets? all right

00:09

return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]

00:15

the outside of sushi. it's the kissing cousin of ROA if that helps. so what

00:20

is return then in this instance huh? well it's just profits. and there's a broader

00:24

frame here to think about. if your company just made five million dollars

00:27

in profits, was that good bad middlin? well if you were a little lemonade stand

00:32

that took 50 grand to start last year and you've made this massive five

00:37

million dollar haul well then yeah wow that's awesome. but if you're Google and

00:41

this year you only made five million bucks well you have tens of billions of

00:45

dollars of capital out there trying to earn lots more while making only five

00:50

million was a huge fail. so these concepts revolve around the balance

00:54

sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]

00:58

asset side is enormous. say with the notional fifty billion dollars in assets

01:03

if you made a ten percent return on your assets or raw ROA

01:09

return on assets well that would mean you netted five billion dollars right?

01:13

ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]

01:17

there. so remember equity or shareholders equity or retained equity on the balance

01:22

sheet yeah this thing right here what equity is the retained profits after

01:26

you've started to build your company and after years and years of building your

01:29

company you would expect to have a lot of retained earnings. so what were the

01:33

returns on that equity or ROE only returns or profits number is the same as

01:39

it was in the ROA calculation only now in the denominator we have equity so if

01:44

your returns were say five billion and your retained equity was twenty billion [equations shown]

01:48

well you had a lovely twenty five percent return this year. twenty five

01:52

percent of twenty billion you know five billion. meaning that in just this one

01:56

year you grew your retained equity one massively. you've become a big harvester [man lifts weights]

02:01

of cash profits from whatever great business it is that you built. well why

02:06

do we care about ROA and ROE? well because capital efficiency

02:11

matters. it's a reflection of how efficient you are, how well you're

02:14

investing your capital how will you're able to grow the business. that is in

02:18

theory you could just sell your assets and go invest them elsewhere, like go

02:22

play an index fund in the stock market, and potentially return better profits

02:26

for your shareholders, and if you can do that well then you're probably going to

02:30

get fired. and there is precedent for this change .the airline industry there [airplane taking off]

02:37

was a time when American Airlines and United Airlines and crash Airlines owned

02:43

all their airplanes. they bought them at 50 million bucks a pop give or take but

02:47

the airline industry is a lousy business producing very low cash profits. every

02:52

time the economic cycle is good the economy is good people are buying

02:56

airline tickets up the wazoo, the Union strike and the airline's try to do

03:00

stupid things with pricing and a bunch of other things happen and all the

03:03

profits go away. anyway so one day a smart MBA employed by the airline said

03:09

hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]

03:14

them and we only need a fraction of our assets or equity or capital to produce

03:18

about the same investment returns for our shareholders. yeah and that's what

03:22

they did. so most airlines these days don't own

03:24

their own planes they lease them from the manufacturer or others and well

03:29

there haven't been any airline bankruptcies lately. and yes the airline

03:33

industry hard to find a better success story. [plane takes off]

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