Financial Ratio Analysis – Profitability Ratio – Return Ratios
Financial Ratio Analysis
Financial ratios are numerical measurements that are employed in the evaluation of businesses. Financial analysts, stock research analysts, investors, and asset managers utilize these statistics to assess the general economic health of organizations with the ultimate goal of improving investment choices. Financial managers and C-suite executives frequently utilize financial ratios to understand better how their companies are operating. Why would a business owner want to use ratio analysis? Comparing two businesses with differing sizes, operations, and management philosophies using ratio analysis is a terrific idea. It’s also an excellent tool to gauge how effectively a firm runs its operations and how profitably the organization is structured.
Profitability Ratio
The ability of a business to create money (profit) in relation to sales, balance sheet assets, operating costs, and shareholders’ equity over a given time period is measured and evaluated by analysts and investors using profitability ratios. They demonstrate how well a business uses its resources to generate profit and shareholder value. Most businesses frequently aim for a larger ratio or value since doing so typically indicates that the company is operating profitably and creating cash flow. The ratios are most helpful when compared to other firms in a similar industry or to earlier time periods. Companies employ a variety of profitability ratios to gain helpful information about the health and performance of their finances. These ratios may all be grouped into one of two groups, Margin Ratios and Return Ratios. The capacity of the business to turn revenues into profits is measured in several ways via margin ratios. Return ratios show how well a corporation can produce profits for its owners.
Return Ratios
- Return On Equity
- Return On Assets
- Return On Capital Employed.
- Return On Invested Capital
- Cash Return On Assets
- Return On Debt
- Return On Retained Earnings
- Return On Revenue
- Risk-Adjusted Return
Return on Equity
Demonstrates the rate of return on the capital equity investors have invested in the company, or the ratio of net income to shareholder equity. Stock analysts and investors pay close attention to the ROE ratio. A company’s stock is frequently recommended for buying on the basis of a positive high ROE ratio. Companies with a high return on equity are typically better at producing cash on their own, which reduces their need on debt funding. ROE offers a straightforward statistic for assessing returns. A company’s competitive advantage can be determined by comparing its ROE to the industry average (or lack of competitive advantage). Return on equity (ROE) examines the company’s bottom line to determine overall profitability for the firm’s owners and investors because it employs net income as the numerator. This ratio is crucial for investors to consider because it ultimately decides how attractive an investment is. Asset effectiveness, financial leverage, and profitability all influence return on equity.
Return on Equity = Net Income / Shareholder Equity
Return on Assets
The return on assets (ROA) metric displays the ratio of net income to total assets for the business. The ROA ratio precisely demonstrates the amount of after-tax profit a business makes for each dollar of assets it owns. It also gauges a company’s asset intensity. A business is deemed to be more asset-intensive the lower the profit per dollar of assets. Large investments are needed to buy machinery and equipment for highly asset-intensive businesses in order to create revenue. Telecommunications services, car manufacturers, and railroads are a few examples of businesses that are frequently very asset-intensive. Advertising firms and software companies are two examples of less asset-intensive businesses. An essential factor for assessing a company’s profitability is the ROA formula. The ratio is often used to compare two businesses in the same industry and size, or to compare the performance of one business over time. Note that while comparing two distinct organizations using ROA, it is crucial to take into account the size of a business and the operations carried out. Varying industries often have different ROAs. Industries that are capital-intensive and depend heavily on fixed assets will often have lower ROAs since their extensive asset bases will increase the formula’s denominator. It is all relative, though, and a company with a sizable asset base may have a sizable ROA if its income is high enough.
Return on Asset = Net Income / Total Assets
Return on Capital Employed
Return on Capital Employed (ROCE), a profitability statistic, gauges how effectively a business uses its capital to produce profits. Investors sometimes use the return on capital employed (ROCE), one of the finest profitability statistics, to decide whether to invest in a particular company. The amount of operating income produced for each dollar invested in the capital is shown by the return on capital employed. As more profits are made per dollar of invested capital, a greater ROCE is always preferable. Calculating a company’s ROCE alone is insufficient, just like with any other financial ratio. Utilized in conjunction with other profitability ratios, including return on equity, return on invested capital, and return on assets. In addition to ROCE, other profitability ratios, including return on assets, return on invested capital, and return on equity, should be utilized to assess a company’s level of profitability.
Return on Capital Employed = EBIT / Capital Employed
Capital Employed = Total Assets – Current Liabilities
Return on Invested Capital
Return on invested capital (ROIC) is a metric used to determine how much profit was made by bondholders and shareholders as well as other capital sources. It is comparable to the ROE ratio, but because it also accounts for returns on capital provided by bondholders, it has a wider reach. ROIC is always represented as a percentage and is frequently annualized or expressed as a trailing 12-month amount. To ascertain whether a company is producing value, it should be contrasted with its cost of capital. Value is being created, and these companies will trade at a premium if ROIC exceeds a firm’s weighted average cost of capital (WACC), the most popular cost of the capital indicator. A return of two percentage points above the firm’s cost of capital is a popular standard for demonstrating value creation. Some businesses operate at a zero-return level, which may not be destroying value but leaves them with no extra cash to invest in future expansion.
Return On Invested Capital = (Net income – Dividends) / (Debt + Equity)
Cash Return On Assets
The proportionate net amount of cash generated as a result of holding a collection of assets is measured by cash return on assets. Since it is exceedingly challenging to conceal the cash flow statistic, analysts frequently use the metric to evaluate the performance of companies operating in the same industry. As a result, the ratio is a very accurate and comparable indicator of asset performance within a given sector. An environment with a lot of assets (like any industrial business) requires a high percentage of cash return on assets since the cash is needed for upkeep, upgrades, and investments in new assets. When there is a significant discrepancy between cash flows and reported net income, as there occasionally is when the accrual method of accounting is utilized, the cash return on assets is very useful. Cash flow is utilized instead of the net income number since it might be deceptive to calculate the return on total assets in this case. The formula is to divide the total average assets by the cash flow from operations when the measure is determined in aggregate for a whole firm.
Cash return on assets = Cash flow from operations / Total average assets
Return On Debt
Return on Debt is a metric for gauging a company’s profitability in relation to its level of debt. The amount of profit made for each dollar a corporation has in debt is referred to as the return on debt. Return on debt measures how much using borrowed money boosts profitability.
Return on Debt = Net Income / Long Term Debt
Return On Retained Earnings
The computation of return on retained earnings (RORE), which reveals how effectively a company’s profits are reinvested after dividend payments, is a sign of its potential for growth. Return on retained profits, or the amount of money set aside for future expansion, informs a lot about the effectiveness and expansion potential of a business. A high RORE suggests that it should invest again in the company. If it can’t figure out how to generate an appropriate return by expanding the firm, a low RORE recommends that it should disperse earnings to shareholders by paying out dividends. RORE tends to decline as a business moves through the industry life cycle. RORE and the retention ratio, commonly referred to as the “plowback ratio,” which calculates the proportion of profits maintained, are connected in this way. When contrasting businesses in the same industry or sector, both metrics are most helpful.