Profitability Ratios

Onyinye Anyakee Written by Onyinye Anyakee · 2 min read >

The Analysis of Financial Statements framework is used extensively by market professionals who analyze financial reports to evaluate company management and value the company’s debt and equity securities. Analysis of financial performance is crucial in assessing prior strategic decisions and evaluating strategic alternatives.

Return on Assets
Suppose we learn that a company reports a profit of #10 million. Does the #10 million profit indicate that the company is performing well? Knowing that a company reports a profit is certainly positive as it indicates that customers value its goods or services and that its revenues exceed expenses. However, we cannot assess how well it is performing without considering the context. To explain, suppose we learn that this company has #500 million in assets. We now assess the #10 million profit as low because relative to the size of its asset investment, the company earned a paltry 2% return, computed as #10 million divided by #500 million. A 2% return on assets is what a much lower-risk investment in governmentbacked bonds might yield. The important point is that a company’s profitability must be assessed with respect to the size of its investment.
One common metric is the return on assets (ROA)—defined as net income for that period divided by the average assets for that period.

Components of Return on Assets
We can separate return on assets into two components: profitability and productivity. Profitability relates profit to sales. This ratio is called the profit margin (PM), and it reflects the net income (profit after tax) earned on each sales dollar. Management wants to earn as much profit as possible from sales. Productivity relates sales to assets. This component, called asset turnover (AT), reflects sales generated by each dollar of assets. Management wants to maximize asset productivity, that is, to achieve the highest possible sales level for a given level of assets (or to achieve a given level of sales with the smallest level of assets). Profitability (PM) and productivity (AT) are multiplied to yield the return on assets (ROA). Average assets are commonly defined as (beginning-year assets – ending-year assets)/2.

Return on Equity
This is another important analysis measure. Return on equity (ROE), which is defined as net income attributable to the parent company’s stockholders divided by average stockholders’ equity, where average equity is commonly defined as (beginning-year equity attributable to the parent company’s stockholders – ending-year equity attributable to the parent company’s stockholders)/2. In this case, company earnings are compared to the level of stockholder (not total) investment. ROE reflects the return to stockholders, which is different from the return for the entire company (ROA).

Whether an ROE is deemed good or bad will depend on what is normal among a stock’s peers. For example, utilities have many assets and debt on the balance sheet compared to a relatively small amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.

A good rule of thumb is to target an ROE that is equal to or just above the average for the company’s sector—those in the same business. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the past few years compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s management is above average at using the company’s assets to create profits.

Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. Still, a common shortcut for investors is to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.



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