4.3. Profitability ratios

Return on sales – ROS

Corresponds to the ratio between the EBIT and the revenues. Through the ROS, we can grasp the operational capacity of the company to generate revenue, regardless of its funding structure.

  • \(ROS=\frac{EBIT}{Revenue}\)

Return on assets – ROA

The return on assets is a ratio between the Net Income and the company’s assets, measuring the income that is being generated by total assets of the company: the efficiency with which the company generates results.

  • \(ROA=\frac{Net\ income}{Total\ Asset}\)

Since the objective of the assets of the company is generate income, this ratio is useful in identifying the efficiency of converting the assets into profits. If the noncurrent assets typically have a greater weight in the total value of the asset, the ROA is a good indicator of the profitability of the investment.

There are also some references to ROA that add financial expenses to the Net income in this equation, because it is assumed that the total asset is financed either by interest bearing debt or equity. However, this is not entirely correct because it does not take into account that the asset may be financed through unpaid liabilities.

When comparing the ROA of two companies you must ensure that these act in the same industry, otherwise the comparison will be out of context.

Asset turnover

The asset turnover measure the efficiency with which the company transforms the total asset into revenues.

  • \(Asset\ turnover=\frac{Revenue}{Total\ asset}\)

Usually, the asset turnover is greater for companies that have smaller margins. This is explained by the fact that the company needs to generate a high volume of revenue to support the remaining costs.

Return on equity – ROE

The return on equity measures the company’s ability to generate income for the investment made by the equity holders, measuring the proportion of the results that were generated by the company for each unit of currency that was invested. The ROE is given by the ratio between the net income and equity.

  • \(ROE=\frac{Net\ income}{Equity}\)

While calculating the ROE for public companies, you must be aware of the existence or not of preferred shares, because the ROE is calculated for common stock. If there are preferred shares, you will need to deduct the value of the preferred shares dividend and adjust the equity based on the common stock.

The ROE is quite important, because unlike other indicators of profitability, the ROE demonstrates the profitability of the equity holders from their point of view and not from the point of view of the company. Investors want higher ROE, as this is the best indication that the company is efficiently using the resources that investors have made available to the company.

Another way to calculate the ROE is through the DuPont formula, by splitting the ROE into three essential components:

  • Net margin;
  • Asset turnover;
  • Financial leverage.

Through this form of calculation, the analyst can identify the points that led to an improvement or reduction of ROE between periods.

  • \(ROE=Net\ margin\times Asset\ turnover\times Financial\ leverage\)
  • \(ROE=\frac{Net\ income}{Net\ revenue}\times\frac{Net\ revenue}{Total\ asset}\times\frac{Total\ asset}{Equity}\)

Return on investment – ROI

Before presenting the calculation of the return on investment, it is important to understand its definition from a financial point of view. The ROI is defined as the perceptual increase (or decrease) of an investment over a given period of time. Thus, ROI corresponds to the return that an investor can expect from the investment.

  • \(ROI=\frac{{Inves}_1-{Inves}_0}{{Inves}_0}\times100\)

Where:

  • Inves0: amount invested;
  • Inves1: amount returned from the investment.

The ROI calculation does not take into account of the temporal structure of the investment. It is possible to obtain the same ROI for an investment with a time horizon of 1 day, 1 month, 1 year, or even 10 years. For this reason, the ROI is usually referred to a period of time, or an annual basis (for example the investment has an annual ROI of 7%).

The ROI can be useful to confront two investments if they refer to the same time period. If a bond has an annual ROI of 15% compared to another that has a 10% ROI, you can assume that the first will be more beneficial (though a completely correct financial analysis will require a comparison of the risk involved).

To use the ROI it is important always take into account its restrictions:

  • Because the ROI does not allow to compare investment during different periods of time: an investor can be led to consider that an investment that gives a ROI of 6% during the period of one year is more than a product that will generate an ROI of 4% during a semester. If both products are continuously renewed investment in the long run, the bi-annual investment will be higher.
  • Because several investment securities having intermediate payment between the initial investment date and the end date of the investment.

Return on capital – ROC

The return on capital refers to the proportion of results in relation to the total capital of the company (the company’s total capital includes the value of equity and interest bearing debt). Instead of using the net income in the numerator, it is used the NOPLAT (Net Operating Profit Less Adjusted Taxes). ROC measures the company’s ability to generate income for its total investment.

  • \(ROC=\frac{NOPLAT}{Equity+Debt-Cash\ and\ deposits}\)

Return on invested capital – ROIC

The return on invested capital is a specialization of the ROC. Once the capital entered in the balance sheet it accumulates the results of previous periods, hence the ROC does not provide a correct view of the profitability of the capital that was actually invested. To do so you can resort to the ROIC, which corresponds to the relationship between the NOPLAT and the value of capital invested.

  • \(ROIC=\frac{NOPLAT}{Invested\ Capital}\)

Invested capital corresponds to the addition of share capital, other equity instruments and debt.

Return on capital employed – ROCE

The return on capital employed is a concept similar to ROIC, but instead of considering the investment structure, uses the capital employed.

  • \(ROCE=\frac{EBIT}{Capital\ employed}\)

The capital employed is given by the deducting the current liabilities to total assets.

  • \(Capital\ employed=Total\ asset-Current\ liabilities\)

 Payout ratio

The payout ratio measures the proportion of distributed results over the net income.

  • \(Payout\ ratio=\frac{Dividend}{Net\ income}\)

Like other indicators, the payout ratio must be seen considering the activity of the company. Companies in technology sectors have a pressure to renew and innovate so as to remain competitive, hence the pressure for investment in new productive capital is higher than that to present high dividends. Companies of sectors whose activity is at a stage of maturity tend to present a higher payout ratios.

This does not mean that companies with higher payout ratio are more interesting for investors than companies with lower payout ratios, because the latter reinvest their net profits in research and development so that in the future those companies are capable of presenting added value to their customers, hence the expectation is that profits and dividends will be higher in the future.

Dividend Yield

The dividend yield compares the value of the share with the value of public company’s market share value. Note that dividend yield is only calculated for public companies. For private held companies, it is harder to state the market value of the share, hence the calculation of the dividend yield is less relevant.

  • \(Dividend\ yield=\frac{Dividend}{Share\ value}\)

Next Section: 4.4. Solvency ratios