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.

  • \(ROS=\frac{EBIT}{Revenue}\)

The following elements were extracted from DFI’s income statement:

Values in EUR 2020 2021 2022 2023 2024
EBIT -68 721,34 126 066,07 762 757,15 2 020 078,57 3 899 382,05
Revenue 0,00 2 480 875,00 5 404 150,00 10 128 250,00 15 940 000,00
ROS 0,00% 5,08% 14,11% 19,94% 24,46%

In 2021, DFI registered an EBIT of 126 066,07€ and it obtained a total revenue of 2 480 875€, which leads to

  • \(ROS=\frac{126\ 066,07}{2\ 480\ 875,00}=5.08\)%

the company is able to convert 5.08% of its total revenue into operating profits (EBIT).

Much like in other ratios, ROS is zero in 2020 since the company does not sell in that year. ROS is a measure of performance and efficiency: you can observe that this ratio more than doubles and continues to grow reaching 24.46% in 2024: DFI becomes more efficient in turning its sales into operating profit.

Example case: Golden Days

The following elements were extracted from Golden Days’ income statement:

Values in USD 2019 2020 2021 2022 2023
EBIT -36 568,23 31 346,94 239 508,90 312 059,11 358 557,55
Revenue 719 250,00 1 433 500,00 1 764 800,00 1 975 500,00
ROS 0,00% 4,35% 16,70% 17,68% 18,35%

Golden Days’ EBIT in 2020 is expected to be 31 346,94$ and its revenue is expected to be equal to 719 250$, which produces a Return on Sales of 4.35%.

  • \(ROS=-\frac{31\ 346,94}{719\ 250,00}=4,35\)%

This means that the company is able to covert 435% of its revenues into EBIT.

Since ROS is a measure of efficiency and profitability, in the following years the ratio increases, meaning that Golden Days becomes more efficient company in turning revenue into operating profits.

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.

Values in EUR 2020 2021 2022 2023 2024
Net Income -72 721,34 87 124,55 559 685,36 1 507 446,43 2 918 994,03
Total Assets 320 789,44 1 182 507,44 2 666 762,25 5 229 773,33 9 427 731,42
ROA -22.66 % 7.36 % 20.98 % 28.82 % 30.96 %

In 2020, Dutch Fabric Innovations originated a net income equal to -72 721,34€ and registered in its balance sheet total assets worth 320 789,44€. Given this, the Return on Assets is

  • \(ROA=-\frac{72\ 721,34}{320\ 789,44}=-22.66\)%

This ratio result is not positive. It shows that the company is not efficient in generating income from its assets. However, this situation is reverted in 2021, when the company becomes more efficient in converting the money that it invests into net income. The business case assumptions state that the DFI-Xpander will have a steady growth of sales.

In 2023 and 2024, the amount of investment made by the company is lower, but the ROA keeps growing.

Example case: Golden Days

The following elements are extracted from Golden Days’ income statement and balance sheet:

Values in USD 2019 2020 2021 2022 2023
Net Income -36 968,23 21 382,86 166 536,23 217 321,38 249 310,28
Total Assets 187 744,09 443 550,43 837 955,75 1 093 579,01 1 386 329,18
ROA -19,69% 4,82% 19,87% 19,87% 17,98%

In 2019, Golden Days registered a net income of -36 968,23$ and 187 744,09$ of total assets. Its Return on Assets is then

  • \(ROA=-\frac{36\ 968,23}{187\ 744,09}=-19,69\)%

In the first year of activity the company’s assets are generating losses and instead of a positive contribution to net income. In 2020, the company manages to turn its ROA positive and create earnings: per dollar of assets, Golden Days generates 0,0482$ of net income.

The ROA increases from 2020 to 2022, as the company becomes more efficient in converting the assets into net income. In 2023, the company faces a small decrease in ROA because total assets grew more than net income.

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.

The following elements are needed from DFI’s income statement and balance sheet:

Values in EUR 2020 2021 2022 2023 2024
Revenue 0,00 2 480 875,00 5 404 150,00 10 128 250,00 15 940 000,00
Total Assets 320 789,44 1 182 507,44 2 666 762,25 5 229 773,33 9 427 731,42
Asset turnover 0,00% 209,80% 202,65% 193,67% 169,08%

In 2021, DFI presented revenues of 2 480 875,00€ and 1 132 038,40€ of total assets, obtaining an Asset Turnover of

  • \(Asset\ turnover=\frac{2\ 480\ 875,00}{1\ 182\ 507,44}=209,80\)%

This percentage means that, per each euro of assets, the company is capable of generating 2.099€ of revenue. DFI’s asset turnover decreases through the years, but that does not mean that the company becomes inefficient because the percentages obtained are above 100%. This decrease is explained by the significant growth in total assets in the last two years. That growth in assets is caused by an accumulation of deposits and cash.

Example case: Golden Days

Values in USD 2019 2020 2021 2022 2023
Revenue 719 250,00 1 433 500,00 1 764 800,00 1 975 500,00
Total Assets 187 744,09 443 550,43 837 955,75 1 093 579,01 1 386 329,18
Asset turnover 0,00% 162,16% 171,07% 161,38% 142,49%

In 2020, Golden Days expects to have a net revenue equal to 719 250,00$ and 443 550,43$ of total assets, obtaining, as a consequence, an asset turnover of

  • \(Asset\ turnover=\frac{719\ 250,00}{443\ 550,43}=162,16\)%

This value tells us that per each dollar of assets, the company can generate 1,62$ of revenue.

We can observe that from 2020 on, the turnover is always above 100%, leading us to conclude that the company is very efficient and has a good performance in managing its assets to have more sale, even if the turnover decreases a little in 2022 and 2023.

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.

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

Let’s consider the following elements from DFI’s income statement and balance sheet:

Values in EUR 2020 2021 2022 2023 2024
Net Income -72 721,34 87 124,55 559 685,36 1 507 446,43 2 918 994,03
Equity 127 278,66€ 264 403,21€ 874 088,57€ 2 381 535,00€ 5 100 529,04€
ROE -57,13% 32,95% 64,03% 63,29% 57,22%

Let’s consider once again DFI’s net income for the year of 2020, as well as its equity. The ROE is

  • \(ROE=-\frac{72\ 721,34}{127\ 278,66}=-57,13\)%

Although negative in the first year, the ROE increases in 2021 and in 2022 and in this later year the company is able to generate 0.6403€ of profit for each invested euro. From 2022 on, the ROE decreases: the total equity is influenced by retained earnings.

Example case: Golden Days

Let’s consider the following elements from Golden Days’ income statement and balance sheet:

Values in USD 2019 2020 2021 2022 2023
Net Income -36 968,23 21 382,86 166 536,23 217 321,38 249 310,28
Equity 163 031,76 384 414,62 650 950,85 868 272,23 1 117 582,52
ROE -22,67% 5,56% 25,58% 25,02% 22,30%

In 2020, the Return on Equity of Golden Days was

  • \(ROE=\frac{21\ 382,86}{384\ 414,62}=5,56\)%

This means that per each dollar of resources made available by investors, the company is able to create 0,0556$ of net income.

From 2020 to 2022, ROE increases, which translates into a better management by the company of the resources previously referred and a better ability to convert those resources into net income.

It is important to note that the negative ROE in 2019 comes from the negative net income of that specific year and the decrease in the same ratio in 2023 is the result of the huge increase in retained earnings from 2022 to 2023, which happen to even outweigh the net income of the latter year.

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.

  • \(ROC=\frac{NOPLAT}{Equity+Debt}\)

Example case: Golden Days

The following elements are extracted from Golden Days’ income statement and balance sheet:

Values in USD 2019 2020 2021 2022 2023
NOPLAT -36 209,93 29 764,36 176 076,28 231 296,95 259 229,08
Equity 163 031,76 384 414,62 650 950,85 868 272,23 1 117 582,52
Debt
Cash and deposits 132 602,39 310 113,80 652 933,68 871 882,38 1 155 553,54
ROC -119,00% 40,06% -8 880,05% -6 406,85% -682,70%

In 2019, with a NOPLAT equal to -36 209,93$, an equity equal to 163 031,76$, zero debt and cash and deposits equal to 132 602,39$, Golden Days presents a Return on Capital of

  • \(ROC=\frac{-36\ 209,93}{163\ 031,76+0-132\ 602,39}=-119,00\)%

This value is very unfavorable because it indicates a very poor capacity of generating income from the total investment.

In 2020, ROC faces an increase, demonstrating a better capacity to manage its total investments and create income from it.

From 2021 on, however, the ratio decreases exponentially, due to the fact that cash and deposits are bigger than equity, putting Golden Days in a very inefficient situation.

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.

Values in EUR 2020 2021 2022 2023 2024
NOPLAT -62 659,49 111 039,95 606 284,55 1 567 547,63 2 978 325,93
Invested Capital 200 000,00 367 000,00 405 000,00 393 000,00 181 000,00
ROIC -31,33% 30,25% 149,70% 398,86% 1 645,48%

Let’s consider DFI’s NOPLAT equal to 111 039,95€, issued capital and other equity instruments with a total of 250 000€, and its debt with a value of 117 000,00€. The sum of issued capital, other equity instruments and debt gives us an invested capital of 367000,00€.

  • \(ROIC=\frac{111\ 039,95}{367\ 000,00}=-31,33\)%

From 2021 on, the ROIC is bigger than the WACC, meaning that the company is creating value from the money that it invests. In fact, ROIC increases as time goes by, proving that the profitability of the invested capital also increases. In 2020 however it is destroying value, since it gets a negative net income and a negative NOPAT after investing.

Example case: Golden Days

Let’s consider the following elements from Golden Days’ activity:

Values in USD 2019 2020 2021 2022 2023
NOPLAT -36 209,93 29 764,36 176 076,28 231 296,95 259 229,08
Invested Capital 200 000,00 400 000,00 500 000,00 500 000,00 500 000,00
ROIC -18,10% 7,44% 35,21% 46,25% 51,84%

In 2019, Golden Days presented the following ROIC calculation:

  • \(ROIC=\frac{-36\ 209,93}{200\ 000,00}=-18,10\)%

From 2020 on, the ROIC is bigger than the WACC, meaning that the company is actually creating value from the money that it invests. In fact, ROIC increases a lot as time goes by, proving that the profitability of the invested capital also increases.

In 2020 however it is destroying value, since it gets a negative net income and a negative NOPAT after investing.

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.

  • \(Capital\ employed=Total\ asset-Current\ liabilities\)
Values in EUR 2020 2021 2022 2023 2024
EBIT -68 721,34 126 066,07 762 757,15 2 020 078,57 3 899 382,05
Capital employed 127 278,66 381 403,21 979 088,58 2 474 535,00 5 181 529,05
ROCE -53,99% 33,05% 77,90% 81,63% 75,26%

In 2020, DFI has 320 789,44€ total assets and 193 510,78€ of current liabilities leading to a capital employed of 127 278,66€. This originates

  • \(ROCE=-\frac{68\ 721,34}{127\ 278,66}=-53,99\)%

Example case: Golden Days

Values in USD 2019 2020 2021 2022 2023
EBIT -36 568,23 31 346,94 239 508,90 312 059,11 358 557,55
Capital employed 163 031,77 384 414,62 650 950,86 868 272,24 1 117 582,52
ROCE -22,43% 8,15% 36,79% 35,94% 32,08%

With an EBIT of -36 568,23$ and a Capital Employed equal to 163 031,77€, in 2019 Golden Days presents a Return on Capital Employed of

  • \(ROCE=-\frac{36\ 568,23}{163\ 031,77}=-22,43\)%

We conclude that, in the first year of the project, the company uses its capital very inefficiently.

However, in 2020 the company already has a positive return, which increases a lot through the years. This means that the profit generated from the capital employed increases, making Golden Days more efficient.

 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