# Financial analysis indicators - profitability

Last updated: 09.11.2016

This series follows the series about Group of financial analysis indicators and describes in detail the indicators of profitability.

## Profitability indicators

Profitability is defined as the ability to achieve profit by using various resources.

Profitability indicators form one group of financial analysis, which are used to evaluate profitability and efficiency of the company management, i.e. the company's ability to produce maximum output (i.e. margin or profit), ideally with minimal inputs.

Group of profitability indicators includes the following indicators:

## Gross margin

Gross margin is one of profitability indicators.

• a difference

• %

## Comparisons

• gross margin % will vary considerably between industries, so comparing companies in different industries makes little sense
• it makes sense to compare with the industry average or with previous years

## Net margin / Profit margin / Return on sales

Net margin (Return On Revenue - ROR" or Return On Sales - ROS ") is one of profitability indicators. It shows how much profit is generated from the unit revenue. It is a useful indicator to control costs as the formula for operating ratio can be easily derived from it.

## Calculation formula

Profit may be EBIT (PBIT), EBT (PBT) or EAT (PAT).

## Comparison

• suitable mainly for comparisons within the company - especially as an indicator of costs increases over time as the decreasing ratio can indicate rising costs, and vice versa
• comparisons between companies makes sense only, if these are very similar businesses in the same industry where similar cost levels and gross margin % can be expected
• appropriate is the comparison with the industry average

Value added (VA) is one of profitability differential indicators and it shows the value that the entity has added to external inputs. Value added is obtained as a difference between revenues from sales of goods/services and costs for inputs (usually direct costs).

There are two alternatives for value added:

Economic Value Added (EVA) evaluates the value (profit) generated by the company during the year in excess of the cost of capital.

## Calculation formula

NOPAT - (invested capital * WACC)

Explanation of terms:

•  NOPAT →Net Operating Profit After Tax (Operating profit after taxes)

• invested capital → total equity and liabilities

•  WACC →Weighted Average Cost of Capital, which must be calculated as well

Market value added (MVA) shows how much value the company delivers to its shareholders. Unlike EVA, MVA evaluates the long-term development and the contribution is evaluated over the entire life of the company (not per year). MVA is used to assess the quality of management work.

## Calculation formula

market value of the company - the amount of capital invested

## Return on capital employed (ROCE)

Return on capital employed (ROCE) is one of profitability indicators and it indicates how efficiently the company manages its long-term resources, i.e. how much profit will be generated by the unit of the long-term investment.

As the result, ROCE provides better information than ROE, because ROE has in the denominator only equity and as such does not consider the amount of loans (i.e. long-term liabilities).

## Calculation formula

* can be in the form of average of the start and end of the period

Profit in the numerator is mostly EBIT, but can be also EBT, EAT, Net income or Net income less the interest on long-term loans.

## Comparisons and recommended values

• general comparatives in the financial analysis
• current cost of borrowing (i.e. mainly interest rate), which should not exceed ROCE. There is no fixed recommended value, but it should be at least 2 times higher ROCE. (10)
• with the corporate WACC, which ROCE should exceed

• problems with comparability as different categories of profit form the numerator
• capital-intensive companies reaching the same profit as companies with less need for capital will have lower ROCE; comparison of companies in different industries can thus be inconsistent
• indicator is dependent on the valuation of assets - e.g. overstatement of fixed assets leads to a decline in ROCE for two reasons:
• overvaluation of assets (higher denominator = lower ROCE)
• overstatement of depreciation = decrease of profit (lower numerator = lower ROCE)

## Return on equity (ROE)

Return on equity (ROE) is one of profitability indicators, which shows how effectively the entity manages resources invested by the shareholders/partners.

## Calculation formula

* can be in the form of average of the beginning and end of the period

The numerator is most often EAT (PAT), often after deduction of dividends to owners of preferred shares.

## Comparison and recommended value

If the entity is financed only by equity, the ROE can be consistent with ROCE.

Comparison with other companies makes sense only within the same industry. It is appropriate to look to the trend development over a longer period of time.

Recommended value depends on many factors (e.g. industry or macro-economic developments), however, it should be over 12% in stable economies (11).

## The main disadvantage of ROE

is that it does not take into account loans (or rather liabilities), so the reason for good ROE can also be higher indebtedness (especially in the case of cheaper loans). Because of this, ROE is mainly used by shareholders (it makes more sense to use ROCE internally) and debt ratios shall be analyzed parallel as well.

## Return on assets (ROA)

Return on assets (ROA) is one of profitability indicators reveals how much profit will be generated by unit of assets. It expresses how effectively the company manages its assets.

## Calculation formula

* often average from the beginning and ending balance

The numerator is usually EAT (PAT) or EBIT.

The higher is the net margin and the higher asset turnover, the higher is ROA.

ROA is usually lower in companies with naturally high asset (e.g. utilities). Conversely, companies with low assets (e.g. services) tend to have higher ROA.

## Comparison and recommended value

Comparisons:

• with companies in the same industry, even if they have different proportion of equity and debt (advantage against ROE). Comparison with companies in different industries does not make much sense because each industry has different net margins, asset turnover and capital intensity.
• appropriate comparison is with the past in the entity

Recommended value: Wikipedia states that ROA above 5% is considered good (12).

## Operating ratio

Operating ratio is one of profitability indicators. Its formula can be easily derived from the profit margin formula (Return on sales). It expresses how much cost is incurred for each unit of sales.

## Comparison

• it is particularly suitable for comparison within the company - especially as an indicator of operating costs (OPEX) increases over time, because increase of the ration can indicate rising costs, and vice versa
• comparisons between companies makes sense only if they are very similar businesses in the same industry where we can expect similar cost level and gross margin %
• appropriate comparison is with the industry average

## Return on costs (ROC)

Return on costs (ROC) is one of profitability indicators. It expresses the amount of profit attributable to unit total cost.

## Comparison

• it is particularly suitable for comparison within the company - especially as an indicator of changes in costs over time as reduction of the ratio can indicate rising costs, and vice versa
• comparisons between companies makes sense only if they are very similar businesses in the same industry where we can expect similar cost level and gross margin %
• appropriate comparison is with the industry average

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