Last month, we looked at the Return on Capital Employed (ROCE) as a measure of the profitability of a company. This allows a potential investor to assess whether to invest in a company and also provides a benchmark for treasurers and other company managers against the current cost of borrowing. This month we look at other profitability ratios.
Return on Equity
Return on Equity (RoE) is often seen as an alternative to using ROCE as a measure of profitability.
The RoE is the earnings available for distribution to shareholders. This can be calculated by using the following equation:
\(RoE \:= \:\frac{ PBIT }{Equity}\)
Where PBIT = Profit before interest and taxes = Total revenue – costs – depreciation
This equation provides the proportional return on each shareholding. It is important for treasurers and financial managers to watch RoE because current and prospective equity investors will track it. As a benchmark of effective use of capital, it is less useful for the treasurer as it ignores the impact of long-term debt.
Net profit margin
Another easy ratio to calculate is the net profit margin. This identifies the proportion of profit for each sale made by the company. It is calculated using the following equation:
\(Net \:profit\: margin \:= \: \frac{PBIT}{Sales}\)
Current and prospective investors will assess the net profit margin as it will give them a view of the underlying profitability of the business. Whereas both RoE and ROCE take a long-term view (they both include equity and ROCE includes long-term debt), the net profit margin provides a shorter term perspective.
In some cases, an investor will want to use a modified equation to calculate the net profit marginafter tax:
\(Net \:profit\: margin \:after \:tax \:= \: \frac{PBIT \:- \:tax} {Sales}\)
This recognises that only the post-tax earnings are available to shareholders.
For the treasurer, it is important to recognise that current and prospective investors and equity analysts will all use a range of different tools and financial ratios in order to try to determine a company’s inherent profitability. All have flaws, so no prudent investor will rely on a single figure when making an assessment. The different measures may also provide contradictory results. A prudent finance function will track all these ratios, especially if the company will be trying to raise additional funds.
