An economic loss incurred by an investment in a project, a business, a stock, or other financial instruments
Written byCFI Team
What is a Negative Return?
A negative return represents an economic loss incurred by an investment in a project, a business, a stock, or other financial instruments. As a result of an investment failure, a negative return happens when the total amount of money received over the investment horizon is less than the capital invested, which hurts investors’ net wealth.
The greater the risk an investment is subject to, the higher the possibility for investors to experience negative returns. Risk management is important to minimize the possibility of negative returns.
Summary
- A negative return is an economic loss from investment in a project, a business, a stock, or other financial instruments.
- Businesses experience negative returns when total expenses are greater than total revenues.
- In the business life cycle, firms at the startup stage are more likely to experience negative returns.
Negative Return in Business
Negative returns can happen in businesses that incur total expenses – including the cost of goods sold, research and development expenses, depreciation expenses, selling, general, and administrative (SG&A) expenses, and so on – which are greater than total revenues.
Businesses with negative returns report negative earnings before tax (EBT), net income, and thus earnings per share (EPS). The shareholders bear greater losses with a negative return on equity (ROE) when a company posts a net loss, while the bondholders of the company may still receive interest payments.
For example, a company with a revenue of $50 million and a total operating cost of $47.8 million for one year, which gives an operating income of $2.2 million. If the company incurs a net interest expense of $3 million, it will report a net loss of -$0.8 million. With $20 million of total shareholders’ equity on its balance sheet, the ROE is -4%.
Sometimes, negative returns are under expectation. Companies in their startup stages are usually expected to generate negative returns, with great amounts of initial capital invested for launching new products and services, as well as developing new markets.
When companies start to grow, they can improve sales and lower costs as a result of economies of scale. Thus, the returns will increase and turn to be positive.
Negative returns may also be caused by unexpected events, such as production disruption caused by natural disasters, unexpected increases in the price of raw materials or a drop in the sales price, and so on.
Companies can purchase insurance to cover the losses caused by certain risk factors– such as cargo loss or damage. They can also hedge the risks of changing prices by holding futures and forwards contracts.
Negative Return in Finance
Investors may receive negative returns from equities, bonds, commodities, real estate, and other types of investments. In the stock market, negative returns can be caused by companies’ net losses.
If the stocks are traded in the public market, stockholders will realize negative returns if they sell the stocks at a lower market price than the price that they purchased at, assuming the capital loss cannot be covered by the dividends received during the holding period.
For example, an investor purchased 100 shares of stock at the price of $56 and sold all of them at $52. A dividend of $2.50 per share was paid during the holding period. Hence, the holding period return (HPR) of the investment is -2.68% ([52-56+2.5]/56).
Fixed income investments generate returns in two ways. One is to sell bonds in the secondary market, and the other one is to hold for interest payments. If a bondholder sells his bonds at a price lower than the purchasing price, he will realize a negative return. It happens when the interest rate increases.
Fixed income investments offer much lower risks of negative returns compared with equity investments. The bond yield is determined in bond contracts, and the return is positive and fixed as long as there is no default.
If a bond issuer defaults, the bondholders will lose a part of or the entire principal, which will cause a negative return. Also, if a company goes bankrupt, its bondholders are given priority in receiving repayments, and common stockholders are the last to be paid.
Tax Treatment of Negative Return
If a company generates a positive EBT, it will need to pay a certain percentage of tax, and the net income will remain positive. Conversely, a company with a negative EBT will file a negative income tax for that year. It can carry the loss forward or backward to offset the positive taxable income for the other years, which will lower the tax liability for those years.
If a company reports a taxable income of $500,000 for Year 1 and -$200,000 for Year 2 with 30% effective tax rate, it will pay $150,000 ($500,000*30%) for tax in Year 1. In Year 2, the company can file an amended tax return to offset $200,000 of the Year 1 income and receive a $60,000 ($200,000*30%) tax refund.
Individuals with negative returns from investments can file capital losses and receive tax deductions for their other taxable capital gains in that year.
Learn More
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