Profitability Ratios
Category: Financial Control Management
There are many criteria by which the company’s performance can be measured:
— Net Sales;
— Net Income;
— Output;
— Added Value.
No one of these measurements, standing by itself, is useful as a comprehensive measure of enterprise performance. Increases in sales are desirable only if they result in increased profits. The same is true of increases in volume of production. Increases in profits, on the other hand, must be related to the capital that is invested in order to attain these profits.
Return on Investment is a prime measure of economic performance. ROI measures the effectiveness of operating performance and determines the ability of the enterprise to survive financially, to attract suppliers of funds, and to reward them adequately. The analyst uses it as a tool in three areas of great importance:
An indicator of managerial effectiveness;
A measure of an enterprise’s ability to earn a satisfactory return on investment;
A method of projecting yearnings.
The basic formula for computing ROI is as follows:
Defining the investment base:
— Total Assets;
— Depreciable Assets;
— Long-term Liabilities plus Equity Capital;
— Shareholders’ Equity;
— Average Investment base.
Return on Total Assets measures the income generating capacity of the enterprise at a given level of investment and structure of assets. ROTA should exceed the inflation rate and should remunerate the invested in the business capital at a higher rate than the cost of money (bank deposits).
Besides, the ROTA represents an evaluation method of managerial decisions in the past. The maximum rate is obtained by performing investments in the higher-yield projects.
The basic formula for Return on Total Assets is:
From the analytical point of view, the profitability of different components of assets is analyzed:
Return on Long-Term Assets;
Return on Realizable Assets:
Inventories
Accounts Receivables
As well as the turnover ratios of different components of assets:
Net Sales/ Cash & Cash Equivalents
Net Sales / Accounts Receivable
Net Sales / Inventories
Net Sales / Long-Term Assets
Net Sales / Current Liabilities
Return on Shareholders’ Equity. The maximization of the Return on Shareholders’ Equity in a long run is the uppermost task of company’s management. The higher return on shareholders’ equity as compared to the return on total assets reflects the positive workings of financial leverage. ROI should be higher than the interest rate in order to attract funds through higher bonuses to the owners of the business.
Return on Shareholders’ Equity is computed based on the formula:
Return on Sales measure the share of net income to net sales and at the same time can be used as an indirect general indicator of manufacturing costs to 1 Leu of sales. Additionally, the ROS serves as a starting point in evaluation of pricing decisions (from the revenue side) and of the operational efficiency (gross profit).
Return on Sales is calculated as follows:
* — Earnings Before Taxes or the Net Income could be also used, depending on the objectives.
Equity Growth Rate indicates the possibilities of earnings growth without resort to external financing. These increased funds, in turn, will earn the rate of return that the enterprise can obtain on its assets and thus contribute to growth in earnings.
Equity Growth Rate by means of earnings retention can be calculated as follows:
* — at the beginning of the period.