Ratio Analysis: How to Measure the Profitability of a Company

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Profits, also called earnings, are the single most important matrices to look at when one is considering to invest in a company. Profitability ratios are those ratios that help us analyze the different profit figures in the profit and loss statement of a company. These ratios help an investor evaluate a company’s profit-generating ability compared to the expenses it needs to incur in order to generate this profit. There are a few different profit amounts that we see on the face of a profit and loss account viz. EBITDA, EBIT, PBT, and PAT. Profitability ratios help us make sense of these amounts.

You may well ask – why is a company generating more profits not considered to be a better company that is generating comparatively lesser profits. The answer is quite simple. Will you consider a big company like Reliance Industries and a smaller company like, say, Star Paper Mills equally efficient if both of them generated equal profits in a particular year? Of course, not. It all comes down to the amount of resources used to generate the profits. The amount of capital and assets at the disposal of Star Paper is insignificant when compared to Reliance Industries. Considering this, if Star Paper is able to generate profits equal to that generated by Reliance, the performance of the former has to be considered to be relatively better.

There are many profitability ratios used by analysts, but I will limit my focus on the three most important ones, studying which I think is sufficient to analyze and compare the profitability of companies. These ratios are –

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1.  EBITDA Margin

2.  Return on Equity

3.  Return on Capital Employed

 

Profitability Ratio #1 – EBITDA Margin

EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) is an important figure in the Profit and Loss Statement of any company. Its importance lies in the fact that it is the purest form of profit figure of the company. The financing decisions (interest costs), accounting decisions (depreciation and amortization) and tax environment (taxes) are not factored into EBITDA. The non-operating effects are thus not included which helps the investor get a better insight into the operational efficiency of the business.

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EBITDA margin compares the profits generated in the normal course of business (i.e. by producing and selling goods and services) to the revenue generated by the company. It is the amount left over after meeting all the direct expenses incurred in the process.

EBITDA Margin = (EBITDA/Revenue) x 100

If the revenue for a period is ₹ 1,00,00,000 and EBITDA is ₹ 30,00,000. So, the EBITDA margin comes to 30%.

EBITDA margin signifies the percentage of revenue left over by after meeting all the expenses directly related to the generation of the revenue. The higher the EBITDA margin the better the performance of the company in relation to its peers.

One must note that EBITDA margin must not be used in isolation but should be used as a tool to compare companies within the same industry. For example, the EBITDA margin of a company in the service industry, say finance industry, will be higher than the one in the manufacturing industry, say paper industry. It helps to compare a smaller company with a larger peer as it calculates the efficiency with which the resources available to the companies are being used.

Having said that, a company must have a decent EBITDA margin, at least in the range of 8 to 10%, to qualify as an investment option for you. A narrow EBITDA margin is not desirable as there is a risk of the company having a low, say 2%, EBITDA margin moving into losses any time, as it is operating at tight margins.

 

Profitability Ratio #2 – Return on Equity (ROE)

Return on equity helps measure the returns generated by a company for its owners. Equity is the contribution in the business by the owners of the company. When we compare the profits generated by a company to the amount contributed in the company by its owners we get the percentage returns the company has generated for its owners, which is technically called return on equity.

Let us take an example to understand this better.

Suppose Company X has the following capital structure all amounts in ₹).

Equity Share Capital (A)

10,00,000

Reserves and Surplus (B)

60,00,000

Total Equity (C = A + B)

70,00,000

Debt (D)

30,00,000

Total Capital Employed (E = C + D)

1,00,00,000

An extract of its profit and loss statement is also given below.

EBIT

20,00,000

Interest @ 10%

3,00,000

PBT (EBIT minus Interest)

17,00,000

Tax @ 30%

5,10,000

PAT (PBT minus Tax)

11,90,000

Return on Equity = PAT/Equity = 11,90,000/70,00,000 = 17%

This is the rate of return generated by Company X for its owners i.e. shareholders. Nobody else has any right on this amount since the interest payable on debt and taxes payable to government have already been considered while computing PAT.

We will look at the interpretation of ROE after explaining the concept of ROCE.

 

Profitability Ratio #3 – Return on Capital Employed (ROCE)

Like return on equity measures the returns generated by a business for its shareholders, return on capital employed (ROCE) measures the returns generated by the business for shareholders and debtholders combined. In other words, ROCE determines the profits earned by the company on the total capital, both equity and debt.

Return on Capital Employed = NOPAT/Capital Employed

Where NOPAT (Net Operating Profit after Taxes) = EBIT (1 – Tax Rate)

In the above example, NOPAT = 20,00,000 (1 – 0.3) = ₹ 14,00,000

So, ROCE = 14,00,000/1,00,00,000 = 14%

NOPAT is the profit leftover for the equity and debt contributors of the company combined. Some analysts, for the ease of calculations, calculate ROCE as EBIT/Capital Employed. But I consider it to be a huge mistake. Taxes belong neither to the equity shareholders nor loan providers. It belongs to the government. Hence taxes shall be excluded. In the above example, if we calculate ROCE using EBIT instead of NOPAT, ROCE would have come to 20%, which is conceptually incorrect and gives a better view about the company that what is true.

 

Interpretation of ROE and ROCE

ROE and ROCE show how well the management has deployed and utilized the funds at their disposal to generate profits. So, higher the ROE and ROCE the better. You are considering to become an investor in the company. In other words, you are considering to contribute to the equity of the company. If the company is generating high returns on equity and also on the overall capital, it is operating efficiently and chances are that you will be rewarded a part of those returns as well.

Is there a benchmark ROE and ROCE that an investor should consider? Yes. Today, any investor can earn more than 7% per annum risk-free rate of return by investing in fixed deposits or debt mutual funds. Investing in equity involves risk and so an investor must have a right to higher returns. I prefer a company that has an ROE and ROCE of at least 15%. I can consider investing in a company delivering lesser returns if the other factors about the company are very positive. But in any case, I would not invest in a company delivering ROE and ROCE of less than 10%.

I use these two matrices to shortlist companies for my investment consideration and also compare companies within and across industries. I also consider the average ROE and ROCE of companies for the last 5 years to get more assurance about the consistency of their profitabilities.

Apart from these three, there are a few other profitability ratios as well viz. returns on assets, return on debt, return on sales, operating margin, net profit margin, etc. But in my opinion, studying the three ratios discussed in this chapter provides sufficient evidence about the efficiency with which capital is being used by a company. All these other ratios suffer from certain disadvantages of their own and so I do not prefer using them. For example, return on assets cannot be used for companies in the service industry, operating margin takes depreciation into consideration and so gives a relatively flawed result than EBITDA margin, and net profit margin takes taxes into consideration which again gives a distorted picture about the company.

I hope you have got a hang of the important profitability ratios discussed above. Please let me know if you have further questions and I’ll be more than happy to understand it better.

Also Read: STOCK INVESTING: MUST HAVE FEATURES TO LOOK FOR IN A COMPANY

See you soon.

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