While the profitability ratios are derived from a blend of profit & loss and cash flow statements, the returns generation efficiency are measured by ratios derived from the combination of profit & loss and balance sheet. Different returns ratios are available for investors, to help evaluate a company's operational efficiency from numerous perspectives, and to obtain a complete picture of a company's true value, financial condition and growth prospects. Some of the widely used ratios are discussed, to help in better understanding for the investors.
Return on Assets (RoA)
The Return on Assets or the Return on Total Assets is a ratio measuring the net profit generated by the total assets during that financial year.
Return on Assets is calculated as:
RoA = Net Profit / Total Assets
A high ROA indicates a healthy functioning and effectiveness of the company, and its ability to generate significant returns from the available assets. Since the total assets vary significantly from a manufacturing company to a service oriented company, it is imperative that RoA of the companies in the same sector be considered for comparison. RoA is also referred to as Return on Investments (RoI).
Also, managers in specific sectors relating to industrial/manufacturing companies prefer ROA in decision making, as it is a measure on the returns made in the business operations, and efficiency.
Return on Net Assets (RoNA)
Similar to return on assets, Return on Net Assets is another profitability measure to identify the effective usage of fixed assets and working capital in generating the net profits for a company. The return on net assets is calculated by dividing the net profit of a company by the sum of its fixed assets and net working capital.
Return on Net Assets is calculated as
RoNA = Net Profit / (Fixed Assets + Net Working Capital)
Higher RONA implies that the company is using its assets and working capital efficiently and effectively and is an indicator of improving profitability and financial performance of the company. This ratio helps to understand and improve the operational performance of a company. The difference between RoA and RoNA is that the current liabilities of a company are considered in the case of RoNA.
Return on Equity (RoE)
The most important of all return ratios, the Return on Equity provides the percentage of net profit in relation to shareholder’s equity. It is a widely used ratio by prospective investors to base their decision regarding investing in the company.
Return on Equity is calculated as:
RoE = Net Profit / Shareholder’s Equity
Higher the RoE, better is the ability of the company in generating profits with the investor’s capital.
At the same time, it is important to note that RoE doesn’t consider the debt on the books of accounts. Since shareholder’s equity is defined as total assets minus the total liabilities, if the liabilities are zero or negligible, then RoE = RoA. However, in most cases, companies do raise capital in the form of debt and hence, RoE > RoA. When the debt on the balance sheet overshadows the equity component, then the RoE’s are higher. RoE is also referred to as the Return on Net Worth (RoNW).
Hence, investors should consider both, RoA and RoE as part of their investment decision.
Return on Capital Employed (RoCE)
A useful measure of the business operations of the company, the Return on Capital Employed expresses the company’s ability to generate a return (before interest and taxes) on the total capital employed. RoCE is an efficiency measure which can help understand the utilization of the company’s available capital.
Return on Capital Employed is calculated as:
RoCE = EBIT / Capital Employed = EBIT / (Total Assets – Current Liabilities)
Higher the ROCE, higher is the efficiency of a company in making use of its available capital to generate profits. This ratio is very helpful when comparing companies in the capital intensive sectors. A thumb rule followed by most analysts is for the RoCE to be atleast twice the finance costs of the company. Any lower RoCE would imply that the company is unable to make appropriate use of its capital sources.
Return on Invested Capital (RoIC)
An assessment measure of the company’s ability to allocate capital to profitable investments is termed as Return on Invested Capital. This ratio measures the efficiency of the total capital employed.
Return on Invested Capital can be calculated in different ways as:
RoIC = (Net Profit – Dividends) / Total Capital Employed
or as, RoIC = {(EBIT) * (1 - Effective Tax Rate)} / Operating Capital, where
Operating Capital = Average of Debt Liabilities + Average of Stockholder's Equity
If the ROIC is greater than the company's weighted average cost of capital (WACC), then the business is adding value and vice versa. For a useful and appropriate interpretation of RoIC, it is important to understand the concept of WACC. The difference between ROIC and WACC is sometimes referred to as a firm’s ‘excess return’ or economic profit.
Weighted Average Cost of Capital (WACC)
An important measure used to calculate the average cost of capital the company has to pay for its investors infusing the funds into the company, is termed as the Weighted Average Cost of Capital or WACC. Simply put, every company finances its assets either through debt or equity or mostly, a mix of both. WACC is the average of the costs of the various types of financing provided by the investors. it is the minimum rate of return the company should earn in order to create value for its shareholders.
A company’s WACC represents the blended cost of capital across all sources of funding, including preferred shares, ordinary shares, and debt. The cost of each type of capital is evaluated by its percentage of total capital.
Weighted Average Cost of Capital is calculated as:
Where,
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Re = cost of equity, in % terms
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Rd = cost of debt, in % terms
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E = market value of the firm’s equity, in Rs.
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D = market value of the firm’s debt, in Rs.
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V = E + D, in Rs.
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E/V = percentage of financing that is equity, a ratio
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D/V = percentage of financing that is debt, a ratio
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Tc = corporate tax rate, in % terms
WACC has many uses, for instance, in a discounted cash flow analysis, where WACC is applied as the discount rate for future cash flows in order to derive the net present value of a business. It can also be used as a threshold rate against which the ROIC performance is appraised. WACC is also essential in order to perform economic value added (EVA) calculations.
DuPont Analysis
To improve the scope of understanding of RoE, Dupont Corporation developed a method for assessing the RoE through an in-depth analysis. Developed in 1912 by Donaldson Brown, a DuPont explosives salesman, this method of analysis is also referred to as the DuPont Model, DuPont equation or the DuPont method. By expanding the RoE into 3 segments of operating efficiency, asset utilization and financial leverage, an investor can understand the appropriate reasons for increase in RoE.
The DuPont ratio is calculated as follows:
RoE (DuPont formula) = (Net Profit / Revenue) * (Revenue / Total Assets) * (Total Assets / Equity)
Where,
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Net Profit Margin (operating efficiency) is represented by the first part - Net profit / Revenue,
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Asset Turnover Ratio is represented by the second part - Revenue / Total assets, and
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Equity Multiplier / Financial Leverage is represented by the third part - Total assets / Equity.
Hence the above formula for RoE can also be written as:
RoE (DuPont formula) = Net Profit Margin * Asset Turnover Ratio * Equity Multiplier
Out of the three parameters indicated, a RoE increase due to a better operating efficiency or higher asset utilization, should be the best option for investors. It implies that the company is either making higher profit margins on its sales or making better use of its available assets or both.
On the other hand, if the RoE is increasing due to financial leverage, it implies that, rather than healthy operations, the net profit increase is due to the financial approach of the company, which is not a preferable option for the company or the investors.
While all the return ratios have their own significance, considering each ratio on a standalone basis may not provide the complete and true picture. Hence, it is suggested to compute all the ratios, use them in conjunction, to compare and contrast the profitability of various companies, and also for better understanding of the business efficiencies.
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Rhea Khanna commented on April 26th, 2019 at 10:42 AM
Is there a book you would recommend I go through to get a deeper understanding of the various ratios and their analysis?