Return on Assets
Return on Assets (RoA) measures the efficiency of assets used in a business to generate profits. It is the most widely used ratio when comparing companies in the same industry. The Return on Assets Ratio is calculated as follows:
Return on Assets = Net Profit before Tax / Total Assets
A low RoA ratio when compared to the industry average indicates an inefficient use of business assets. However, a high RoA figure does not necessarily indicate that a company is using its assets efficiently. A company carrying highly depreciated and old assets will also have a high RoA figure. Also, since assets are carried at historical values, they remain understated during inflationary periods. Hence, RoA during times of high inflation may be misleading.
Companies in industies which employs significant fixed assets (for example, infrastructure companies) tend to have a lower RoAs compared to industries that employ fewer amounts of fixed assets (Technology companies).
Return on Equity
This ratio is the most commonly used ratio by equity shareholders to judge the profitability of their funds invested in a firm. Return on Equity (RoE) is calculated as:
RoE = (Profit after tax – Preference Dividends paid) / Net Worth
Net Worth includes all contributions made by equity shareholders, including paid-up capital, reserves and surplus. You should keep in mind that financing decisions by management affects RoE. For example, assume that companies A and B earn similar operating profits of $100 and have the same tax rate of 30%. Also assume that both the companies have employed capital of $1000. However, company A employs only equity and company B employs debt (at 15% interest rate) and equity in the ratio of 3:7. The following table depicts the difference in RoE of both the companies based on these assumptions.
|Net Profit margin||70.00%||59.50%|
|Return on Equity||7.00%||8.50%|
In this case, even though both the companies have earned similar operating margins, company B has a higher return on equity (8.50%). This is due to the leverage used by company B. While B provides higher return on equity to shareholders, it is also riskier compared to A which carries no debt. Similarly, RoE is also influenced by the average cost of debt and tax rates.
Return on Capital Employed
Return on Capital Employed (RoCE) indicates the efficiency and profitability of a company’s capital investments. It is calculated as:
RoCE = Earnings before Interest and Tax / (Total Assets – Current Liabilities)
ROCE should always be higher than the rate at which the company borrows, i.e. it should earn more than the cost of funds it applies in the business. The company may face liquidity issues if the interest costs on its debt are more than the return gained on the employed capital.
For a company that has fluctuating capital, a more suitable ratio would be Return on Average Capital Employed, which uses the average of opening and closing capital employed during a given period of time.
While all the profitability ratios provide valuable insight into a company’s financial performance during the operating cycle, the analyst should be aware of manipulation techniques used for distorting the income statement before drawing any conclusions based upon these profitability ratios.