Tuesday, August 16, 2011

Profitability Ratios (RoA, RoC, RoE) - I

Capital, be it debt or equity, comes at a cost. It is, therefore, important to know if a company is generating enough returns to cover that cost. If the returns are higher than the cost, the company is adding value, else value is being lost. We use profitability ratios, such as return on assets, return on capital employed and return on equity, to estimate this value addition.

1 Return on Assets (RoA)

RoA shows us how much a company has earned on each rupee value of its assets. Usually, it is calculated by dividing a company’s net profit by its total assets. Sometimes, however, operating income is used instead of net income. The value of ROA, therefore, depends on the choice between net and operating income. A higher ROA means better profitability and vice-versa.

2 Return on capital (RoC)

Also known as return on capital employed (RoCE), it is the ratio of a company’s earnings to its capital. The ‘capital’ used to calculate this ratio includes both debt and equity capital. The measure of earning would be operating profit less taxes, not net profit. This is because net profit is shared only by equityholders, whereas operating profit is shared by both debt and equity suppliers. It is always desirable to have a high RoCE as it is one of the most important measures of the efficiency of a company’s capital investments.

3 Return on equity (RoE)

RoE is the ratio of a company’s earnings to its capital. However, unlike RoC, the ‘capital’ used here is just equity capital. Net profit is used as a measure of return.

RoE analysis. Although it is desirable to have a high RoE, one should check the reasons behind a high figure. To wit, we usually break RoE into three variables, though some may like to break it even further. These are net profit margin, asset turnover and financial leverage. An increase in any of these three variables beefs up the RoE. Note that while high net profit margin and asset turnover are positive for a company, higher financial leverage (or the amount of debt in a company’s overall capital structure) increases the risk. Therefore, high RoE due to high financial leverage calls for caution.

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