CHAPTER 4 PROFITABILITY ANALYSIS OF SAMPLE REAL ESTATE COMPANIES

Transcription

1 CHAPTER 4 PROFITABILITY ANALYSIS OF SAMPLE REAL ESTATE COMPANIES 83

2 Profit Analysis In managerial economics, profit analysis is a form of cost accounting used for elementary instruction and short run decisions. A profit analysis widens the use of information provided by breakeven analysis. An important part of profit analysis is the point where total revenues and total costs are equal. At this breakeven point, the company does not experience any income or any loss. Components of Profit Analysis The key components involved in profit analysis include: Selling price per unit Level or volume of activity Total fixed costs Per unit variable cost Sales mix Assumptions in Profit Analysis The profit analysis incorporates the following assumptions: Unvarying sales price, Unvarying variable cost per unit, Unvarying total fixed cost, Unvarying sales mix, Units sold equal units produced. These are largely linearizing and simplifying assumptions, which are frequently presumed in elementary discussions of costs and profits. In more advanced accounting treatments, costs and revenue are non linear thus making the analysis more complicated. 84

3 Applications of Profit Analysis The profit analysis is helpful in simplifying the calculation of breakeven in breakeven analysis. Besides, it is generally helpful in simple calculation of Target Income Sales. Moreover, it also simplifies the process of analyzing short run trade-offs in operational decisions. Limitations of Profit Analysis The profit analysis is a short run and marginal analysis which presumes the unit variable costs and the unit revenues to be constant. This is, however, appropriate for small deviations from current production and sales. Besides, the profit analysis also presumes a neat division between variable costs and fixed costs, though in the long run, all costs are variable. Therefore, for longer term profit analysis considering the complete life-cycle of a product it is preferable to carry out activity-based costing or throughout accounting. Profitability Analysis: Profitability is the capacity to earn profit of a business. Profitability is the main factor of a business. It reflects success and growth of the business. It makes a business in such a sound position to face the various future crises in the industry and economy. Profitability of a company is measured through different profitability ratios. Profitability ratios: Profitability ratios measure a company s ability to generate earnings relative to sales, assets and equity. These ratios assess the ability of a company to generate earnings, profits and cash flows relative to some metric, often the amount of money invested. They highlight how effectively the profitability of a company is being managed. Common examples of profitability ratios include return on sales, return on investment, return on equity, return on capital employed (ROCE), cash return on capital invested (CROCI), gross profit margin and net profit margin. All of these 85

4 ratios indicate how well a company is performing at generating profits or revenues relative to a certain metric. Different profitability ratios provide different useful insights into the financial health and performance of a company. For example, gross profit and net profit ratios tell how well the company is managing its expenses. Return on capital employed (ROCE) tells how well the company is using capital employed to generate returns. Return on investment tells whether the company is generating enough profits for its shareholders. For most of these ratios, a higher value is desirable. A higher value means that the company is doing well and it is good at generating profits, revenues and cash flows. Profitability ratios are of little value in isolation. They give meaningful information only when they are analyzed in comparison to competitors or compared to the ratios in previous periods. Therefore, trend analysis and industry analysis is required to draw meaningful conclusions about the profitability of a company. Some background knowledge of the nature of business of a company is necessary when analyzing profitability ratios. For example sales of some businesses are seasonal and they experience seasonality in their operations. The retail industry is example of such businesses. The revenues of retail industry are usually very high in the fourth quarter due to Christmas. Therefore, it will not be useful to compare the profitability ratios of this quarter with the profitability ratios of earlier quarters. For meaningful conclusions, the profitability ratios of this quarter should be compared to the profitability ratios of similar quarters in the previous years. Gross profit margin Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of sales) to sales revenue. It is the percentage by which gross profits exceed production costs. Gross margins reveal how much a company earns taking into consideration the costs that it incurs for producing its products or services. Gross margin is a good indication of how profitable a company is at the most fundamental level, how efficiently a company uses its resources, materials, and 86

5 labour. It is usually expressed as a percentage, and indicates the profitability of a business before overhead costs; it is a measure of how well a company controls its costs. Gross margin measures a company's manufacturing and distribution efficiency during the production process. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations, the better the company is thought to control costs. Investors use the gross profit margin to compare companies in the same industry and also in different industries to determine what are the most profitable. A company that boasts a higher gross margin than its competitors and industry is more efficient. Calculation (formula) Gross margin is calculated as gross profit divided by total sales (revenue). Gross profit margin = Gross profit / Revenue (net sales) Both variables are shown on the income statement or statement of comprehensive income. EBIT (Earnings before Interest and Taxes) EBIT (Earnings Before Interest and Taxes) is a measure of an entity's profitability that excludes interest and income tax expenses. Interest and taxes are excluded because they include the effect of factors other than the profitability of operations. EBIT (also called operating profit) shows an entity's earning power from ongoing operations. Calculation (formula) EBIT = Profit (loss)* + Finance costs + Income tax expense* * from continuing operations Earnings before Interest after Taxes (EBIAT) Earnings before Interest and After Taxes are used to measure the ability of a firm to generate income through various operations during a specific course of time. 87

6 Calculation (formula) Earnings before Interest and After Taxes = Revenue - Operating Expenses + Non-operating expenses. Earning before Interest and After Taxes represents the availability of cash in a company s account that may be used to pay off the amounts of the creditors during liquidation. It is proves to be useful when the company incurs amortization of the assets. If Earnings Before Interest And After Taxes is compared with the earnings before interest and taxes, then it must be said that it is a less common measure. The financial analysts use Earnings Before Interest And After Taxes when they want to take a look at the performance of the company in the particular accounting cycle in which it is currently operating. We all know that taxes are set by the government and a person who is running a company cannot influence them according to his own will like the way he can take decisions regarding the operations of his company. Therefore, with the use of Earnings Before Interest And After Taxes, the financial analysts consider taxes as a cost of doing business. The reason for this is that a company is legally bound to pay the taxes otherwise it cannot operate. Earnings Before Interest And After Taxes helps to reduce the financing effects which in turn enables the investors to see that whether the company is profitable or not and what is the status of its financial performance. Whenever a company s Earnings Before Interest And After Taxes is being analyzed, it must be done with the combination of other things too like working capital, debt payments, net income and capital requirements. EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)is an indicator of a company's financial performance. It measures a company s financial performance by computing earnings from core business operations, 88

7 without including the effects of capital structure, tax rates and depreciation policies. EBITDA is a rough approximation for cash flow; it ignores many factors that impact on true cash flow, such as debt payments. Even so, it may be useful for evaluating firms in the same industry with widely different capital structures, tax rates, and depreciation policies. EBITDA is a "calculated" indicator which is not defined under GAAP. EBITDA is often used in various evaluating ratios, such as EV/EBITDA and EBITDA margins. EBITDA demonstrates to investors the ability to have a return on their investments. Calculation (formula) EBITDA = Revenue Expenses (excluding tax, interest, depreciation, amortization) EBITDARM Earnings before Interest, Taxes, Depreciation, Amortization, Rent and Management fees, EBITDARM refers to a financial performance measure which is used in comparison to more common measures like EBITDA in situations where the rent and management fees of a company represent a larger-than-normal percentage of operating costs. EBITDARM is not a measure in accordance with GAAP (Generally Accepted Accounting Principles), rather is used for internal analysis and for presenting it to investors and creditors. Moreover, it is also reviewed by credit rating agencies while assessing the overall debt servicing ability and credit rating of a company, which is an important factor for many companies presenting this measure carry high debt loans. Above all, measures like EBITDARM are most useful to investors if they are evaluated in conjunction with net earnings and more refined non-gaap measures like EBIT and EBITDA. Calculation (formula) 89

8 Unlike the lengthy acronym, the computation of EBITDARM is not as lengthy and complicated. The main steps involved in calculation of EBITDARM include: Compute the net income by calculating the difference between total income and total expenses. The total income can be defined as the amount of money received for services, labor, and sale of goods. Total expenses, on the contrary, are the incurred on use of an asset or incurring a liability. Determine the amount of income taxes, which is the total amount of taxes paid to federal state and local governments. Determine the interest charges, which include the fee paid to the companies for using the credit or currency. The next step is to establish the depreciation costs. The term depreciation is used to define a cash or non-cash asset that loses value over time either through aging, wear and tear or the assets getting obsolete. Going further, estimate the amount of amortization, rent for building and equipment, and the cost of management fees. As a final step, add up all the expenses, i.e. depreciation + interest + taxes + amortization + rent + management fees, and subtract it from the total revenue, thus reaching EBITDARM. Earnings before taxes (EBT) Earnings before taxes (EBT)can be defined as the money retained by a company before deducting the money due to be paid as taxes. The Earnings before Tax quantifies the operating and non-operating profits of a company before taxes are considered. It is similar to profits before taxes. Moreover, this performance indicator provides a level measure to compare companies in distinctive tax jurisdictions. Significance of Earnings before Tax The EBT holds great significance for investment analysts as it provides them with useful info required for evaluating a business entity s operating performance without considering the tax implications. By removing the tax factor, Earnings before Tax is helpful in minimizing a variable which might differ for various 90

9 companies, so as to focus the analysis on operating profitability as a remarkable quantification of performance. This type of analysis is important, specifically, when comparing companies across a single industry. Calculation (formula) The general formula used for computing the earnings before tax is: EBT = Revenue - Expenses (excluding tax) Calculating Earnings before Tax The main steps involved in computing the EBT include: Collect the information about all the income earned. This income can be received from different sources, counting sales, commissions, or rental income. Some other sources of income include service income, interest on CDs or bank accounts, and bonuses. The next step involves determining the deductible expenses. If you run a business, the most common expenses would include rent or debt service, utilities, and cost of goods sold. Besides, individuals will keep a record of their medical expenses, unreimbursed costs from their employment and charitable contributions, if any. As a final step, deduct the deductible expenses from the income earned thus obtaining the resulting answer as earnings before tax. Net Profit Margin Net profit margin (or profit margin, net margin, return on revenue) is a ratio of profitability calculated as after-tax net income (net profits) divided by sales (revenue). Net profit margin is displayed as a percentage. It shows the amount of each sales dollar left over after all expenses have been paid. Net profit margin is a key ratio of profitability. It is very useful when comparing companies in similar industries. A higher net profit margin means that a company is more efficient at converting sales into actual profit. 91

10 Calculation (formula) Net profit margin = Profit (after tax) / Revenue Both variables are shown on the income statement or statement of comprehensive income. Cash Return on Capital Invested (CROCI) Cash return on capital invested (CROCI) is metric that compares the cash generated by a company to its equity. It is also sometimes known as cash return on cash invested. It compares the cash earned with the money invested. This is a cash flow based measure as opposed to earnings based metric. Cash flow based metrics are more important for the investors because it is ultimately the cash that matters to the investors. Besides, cash flow based measures are superior to earnings based measures because the earnings can be manipulated with the help of accounting policies. A positive point about the cash return on capital employed is that it removes the effect of non-cash expenses such as depreciation and amortization. These noncash items are of less significance to the investors because they are ultimately interested in the cash flows. This metric was developed by the Deutsche Bank Group and it is based on an economic profit model. Although there are no standards but the higher this measure is the better it is. A company with a higher cash return on capital invested is a good investment opportunity. Calculation (formula) Cash return on capital invested is calculated by dividing the earnings before interest, taxes, depreciation and amortization by the total capital invested. Cash Return on Capital Invested = EBITDA / Capital Invested The capital invested is defined as the equity capital and preferred shares. Long term loans are also included in the capital employed. Sometimes it is also referred to as capital employed. It can be calculated from the balance sheet by adding 92

11 equity and long-term loans. Another method of calculating capital invested is by subtracting the current liabilities from the total assets. Norms and Limits Investors should not base their decision on only this measure. It should be used with other financial ratios of performance measurement to better assess the performance of a company. It should be compared with the historical data and data from other companies to see whether the performance of a company is improving or deteriorating over time. Return on capital employed (ROCE) Return on capital employed (ROCE) is a measure of the returns that a business is achieving from the capital employed, usually expressed in percentage terms. Capital employed equals a company's Equity plus Non-current liabilities (or Total Assets Current Liabilities), in other words all the long-term funds used by the company. ROCE indicates the efficiency and profitability of a company's capital investments. ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice versa; a good ROCE is one that is greater than the rate at which the company borrows. Calculation (formula) ROCE = EBIT / Capital Employed = EBIT / (Equity + Non-current Liabilities) = EBIT / (Total Assets - Current Liabilities) A more accurate variation of this ratio is return on average capital employed (ROACE), which takes the average of opening and closing capital employed for the time period. One limitation of ROCE is the fact that it does not account for the depreciation and amortization of the capital employed. Because capital employed is in the denominator, a company with depreciated assets may find its ROCE increases without an actual increase in profit. 93

12 Net Operating Profit Less Adjusted Taxes (NOPLAT) NOPLAT is Net Operating Profit Less Adjusted Taxes. It is a measurement of profit which includes the costs and the tax benefits of debt financing. In other words, it can be said that NOPLAT is the earnings before interest and taxes after making the adjustments for taxes. It is a firm s total operating profit where adjustments for taxes are made. It shows the profits that are generated from the core operations of a company after making the deductions of income taxes which are related to the company s core operations. For the creation of DCF models or the discounted cash flow models, often NOPLAT is used. Overview The effects of capital structure are removed by NOPLAT so it is preferred to net income. NOPLAT is somewhat similar to EVA model in the way that economic profit is derived by deducting the monetary cost of all types of capital including equity and debt from NOPLAT. It is important for an analyst to make proper adjustments related to inter-temporal tax differences, non operating income taxes, amortization and others, but many times, a simple formula to reflect de-levered profit is applied by eliminating the effects of debt tax shield. Calculation (formula) Operating earnings = After-tax operating profit + Interest paid * (1 - tax rate) NOPLAT is also called net operating profit after tax (NOPAT). NOPLAT is calculated by the following formula: NOPLAT = Operating Income x (1 tax rate) NOPLAT is an important measure in different types of financial analyses because it makes use of only operating income and provides a clear picture of operating efficiency. This is crucial as net income is reduced by interest payments on debts and which further reduce the tax expense of the company. It is also used for calculating EVA. 94

13 OIBDA (operating income before depreciation and amortization) OIBDA (operating income before depreciation and amortization) is a non Generally Accepted Accounting Principle related measurement of finance based performance utilized by entities to display profitability in continuing business related activities that do not take into consideration the effects of tax based structure and capitalization. At times OIBDA also does not take items like changes in accountancy principles/standards that do not indicate core results of operating, losses/earnings of subsidiaries and income generated from operations of subsidiaries that were discontinued. This particular measure is becoming prominent as entities are distancing from utilizing earnings before taxes, amortization, interest and depreciation. Both these measures are more or less similar. The only difference comes in terms of income related numbers used by both the measures. As far as OIBDA is concerned, the calculation is done using Generally Accepted Accounting Principle net operation income whereas in EBITDA, the same is done using GAAP net income. Therefore, for a public company, it is always better to report earnings based on OIBDA calculation as it is always higher than any other figure. The traditional procedure takes each and every expense into consideration, whereas OIBDA does not follow that method and reports only those expenditures that are directly related to the regular operation of any business such as raw material costs, shipping fee and employee salaries. So, if a public company is looking to impress the stakeholders, then it is advisable that it reports earnings after calculating OIBDA. Calculation (formula) OIBDA = Operating income + Depreciation + Amortization 95

14 The Advantages for Public Companies to Report Earnings after OIBDA Calculations Earnings related reports issued by public companies are usually considered to be their report cards., Each and every public company trading in the stock market releases a detailed report for its stockholders on a quarterly basis and it is through this report that it offers its stakeholders with details such as the amount of money earned during the three month period, amount that was spent by the company and the amount of money that now remains with it (i.e. profit). The primary aim of this report is to make existing investors happy and also draw the attention of new investors towards the performance of the company. In addition to this, it is through these reports that a company acquires its OIBDA (operating income before depreciation and amortization) figure. By opting to register earnings in the form of operating income before depreciation and amortization, an entity can get rid of a number of non-operating expenditures like long-term investments in equipment, tax related deductions and any sort of investments in intangible assets such as trademarks as well as further add these entire loses all over again into the profit column. In order to determine why OIBDA is of relevance, one needs to understand the manner in which business accountancy works. Ideally, if an accountant wishes to do calculations to figure out the exact profit amount, he/she would refer to GAAP that has been created by the FASAB (Federal Accounting Standards Advisory Board). He would first take gross income into account and then deduct all the expenses to find out the profit amount. But in actual business practice, not every expense and income is treated on an equal basis. Accountants must take operating expenses and income as well as non-operating expenses and income into account. Since many entities as well as investors are of the view that it is merely operating profit that provides a real indication of an entities value as well as everything else, it is necessary to calculate OIBDA. 96

15 Operating Expense Ratio Operating expense ratio can be explained as a way of quantifying the cost of operating a piece of property compared to the income brought in by that property. Operating expense ratio can be explained as a way of quantifying the cost of operating a piece of property compared to the income brought in by that property.the operating expense ratio (OER) is a helpful tool in carrying out the comparisons between the expenses of analogous properties. If a particular property piece features a high OER, an investor should take it as a warning signal and look into the matter for why is the OER high. The investors using this ratio can further compare any type of expense including insurance, utilities, taxes and maintenance, to the gross income, and the sum of all expenses to the gross income. The main items included in the operating expense include property management, property taxes, utilities, wages, insurance, fees, supplies, repairs and maintenance, advertising, accounting fees, attorney fees, pest control, trash removal, and similar more. However, the items not included in operating expenses are personal property, loan payments, and capital improvements. Calculating the operating expense ratio The operating expense ratio is, generally, calculated by dividing the operating expense of a property by its gross operating income. Calculation (formula) Operating Expense Ratio = Operating Expenses / Effective Gross Income Importance of operating expense ratio The importance of operating expense ratio lies in the fact of it being an indicator of the efficiency level of managing a property. A lower operating expense ratio indicates a greater profit for the investors. in simple words, the operating expense ratio reflects the percentage of a property s income which is being utilized to pay 97

16 operational and maintenance expenses. Moreover, the operating expense ratio also represents individual operating expenses items in the form of a percentage of the effective gross income and is also helpful in identifying potential problems. Operating Margin Operating margin (operating income margin, return on sales) is the ratio of operating income divided by net sales (revenue). OPERATING RATIO = COST OF GOOD SOLD+ OP. EXPENSES * 100 SALES Operating profit margin ratio The operating profit margin is a type of profitability ratio known as a margin ratio. The information with which to calculate the operating profit margin comes from a company's income statement. Operating Profit Margin = Operating Income/Sales Revenue = % Operating income is often called earnings before income and taxes or EBIT. EBIT is the income that is left, on the income statement, after all operating costs and overhead, such as selling costs and administration expenses, along with cost of goods sold, are subtracted out. Operating Profit Margin = EBIT/Sales Revenue = % The operating profit margin gives the business owner a lot of important information about the firm's profitability, particularly with regard to cost control. It shows how much cash is thrown off after most of the expenses are met. A high operating profit margin means that the company has good cost control and/or that sales are increasing faster than costs, which is the optimal situation for the company. Operating profit will be a lot lower than the gross profit since selling, administrative, and other expenses are included along with cost of goods sold. As the company grows and sales revenue grows, overhead, or fixed costs, should become a smaller and smaller percentage of total costs and the operating profit 98

17 margin should increase. A high operating profit margin usually means that the business firm has a low-cost operating model. Overhead Ratio Overhead ratio is the comparison of operating expenses and the total income which is not related to the production of goods and service. The operating expenses of a company are the expenses incurred by the company on a daily basis. The operating expenses include maintenance of machinery, advertising expenses, depreciation of plant, furniture and various other expenses. These expenses when controlled can provide a company by maintaining the quality of the business. All companies want to minimize overhead expenses so that it helps them understand and manage the revenues of the company. By definition, the ratio of operating expenses to the sum of taxable equivalent net interest income and other operating income. The overhead ratio shows the proportion of expenses to total income which cannot be used for production of goods and services. Formula for overhead ratio Overhead ratio = Operating Expenses / (Taxable net interest income + Operating income) Operating income is the company s earning capacity from the manufacture of goods and services. Operating expenses are the day to day expenses of a business that can include rent, utilities and others. A company would try as much as it can to lower these expenses without it affecting the production of goods and services so as to maintain the competition in the industry. Cutting down of these expenses has a positive effect on the ratio, but the quality of production of the goods and services have to be maintained so that the business can last. It is important for every business to maintain a lower overhead ratio as it can help them with their production. Some overhead expenses can be curbed while most 99

18 others can be avoided completely, and minimizing these overheads would benefit the business and its returns. Relative Return Relative return refers to the return achieved by an asset over a specific time period contrasted to a benchmark. The relative return is computed as the difference between the absolute return reached by the asset and the return reached by the benchmark. As explained, relative returns are used generally while reviewing the performance of a mutual fund manager. Since mutual fund holders are charged management fees, they expect a manager to reach higher returns as contrasted with the benchmark index. Calculating relative return Relative return reveals how the return from an asset is compared with a benchmark. The benchmark can be anything from the performance of a similar asset to the performance of an entire stock index. The choice of benchmark depends upon the investor. Relative return is useful as it provides the investor with an idea about the performance of one asset compared to that of another. The main steps involved in the estimation of relative return include: 1. Estimate the absolute return. The absolute return refers to the return showed by an investment for a specific period. For instance, the portfolio of Investor A shows a gain of 15% in the previous year. 2. Calculate the benchmark return. The return can be calculated for any benchmark an investor wants to contrast the investment with. The return is generally found while researching an index or computing the return on similar investment which is the benchmark. In the aforementioned example, the benchmark is a stock index. The index for all of Investor A s stocks in the portfolio feature an overall return of 8% for the year. 100

19 3. Deduct the benchmarked return from the absolute return thus reaching the relative return. In the example above, 15% - 8% gives a relative return of 7%. Return on Assets (ROA) Return on assets (ROA) is a financial ratio that shows the percentage of profit that a company earns in relation to its overall resources (total assets).return on assets is a key profitability ratio which measures the amount of profit made by a company per dollar of its assets. It shows the company's ability to generate profits before leverage, rather than by using leverage. Unlike other profitability ratios, such as return on equity (ROE), ROA measurements include all of a company's assets including those which arise from liabilities to creditors as well as those which arise from contributions by investors. So, ROA gives an idea as to how efficiently management use company assets to generate profit, but is usually of less interest to shareholders than some other financial ratios such as ROE. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry. Capital-intensive industries (such as railroads and thermal power plant) will yield a low return on assets, since they must possess such valuable assets to do business. Shoestring operations (such as software companies and personal services firms) will have a high ROA: their required assets are minimal. The number will vary widely across different industries. This is why, when using ROA as a comparative measure, it is best to compare it against a company's previous ROA figures or the ROA of a similar company. Calculation (formula) Return on assets is calculated by dividing a company's net income (usually annual income) by its total assets, and is displayed as a percentage. There are two acceptable ways to calculate return on assets: using total assets on the exact date or average total assets: ROA = Net Income after tax / Total assets (or Average Total assets) 101

20 Instead of net income, comprehensive income can be used as the formula's numerator (see statement of comprehensive income). Return on Average Assets (ROAA) Return on Average Assets (ROAA) can be defined as an indicator used to evaluate the profitability of the assets of a firm. Putting it simple, this return on average assets indicates what a company can do with what it possesses. Generally, it is used by companies, banks and other financial institutions as an appraisal for determining their performance. Being calculated at period ends, i.e. quarters, years etc., the return on average assets does not reveal all the highs and lows. It is, rather, just an average of the period. As stated by Investopedia, the return on average assets is estimated by dividing the net income by average total assets. The obtained ratio is expressed as a percentage of the total average assets. Moreover, the metric reflects the efficiency of a company in utilizing the assets. Also, the ratio is helpful to aide comparison among companies in the same industry. Calculation (formula) ROAA = Net Income / Total Average Assets Applications of Return on Average Assets The return on average assets is useful in measuring profits against the assets used by a company for generating profits. The ratio is an important indicator of the intensity of assets of a company. A lower ROAA ratio reflects a higher assetintensity of the company, and vice versa. Besides, a more asset-intensive company requires a larger amount of money to continue producing revenue. Moreover, the return on average assets ratio is also useful for investors in assessing the financial strength and efficiency of a company for using its resources. It is also imperative for the management to determine the performance of a company against its planned business goals, or market competitors. 102

21 Return on Average Capital Employed (ROACE) The return on average capital employed (ROACE) is a ratio that reveals the profitability against the investments made in the company. The ROACE is different from the return on capital employed for it counts the average of the opening and closing capital for the specific period contrasting to only the capital figure at the end of a period. The return on average capital employed is helpful for analyzing businesses in capital-intensive industries, oil for example. The businesses capable of squeezing higher profits from a smaller amount of capital assets will feature a higher ROACE as compared to those which are not efficient in transforming capital into profits. The ROACE is calculated as: ROACE = EBIT / (Average Total Assets - Average Current Liabilities) Capital Employed = Total Assets Current Liabilities = Equity + Non-current Liabilities The key steps involved in calculating the Return on Average Capital Employed include: 1. Deduct the operating expenses from the revenue to obtain the company s earnings before interest or tax (EBIT). 2. Deduct the value of liabilities from the value of total assets to obtain capital employed at the begging of the period plus at the end of the period and divide it by Divide the EBIT by the result obtained as capital employed to obtain the ROACE. Important tips It is important for the investors to be cautious while using the ROACE as the capital assets, like refinery, can be depreciated over passing time. If an asset is generating the same amount of profit over every period, the depreciation of asset 103

22 will lead to a higher ROACE which is less valuable. This reveals the company making good use of capital, although the company is actually not making any additional investments. The return on average equity (ROAE) The return on average equity (ROAE) refers to the performance of a company over a financial year. This ratio is an adjusted version of the return of equity that measures the profitability of a company. The return on average equity, therefore, involves the denominator being computed as the summation of the equity value at the beginning and the closing of a year, divided by two. Estimating the return on average equity can provide a more accurate picture of the company s corporate profitability, particularly in situations where the value of shareholders equity has changed significantly during the financial year. In circumstances, where the value of shareholders equity does not alter or alters by a small amount during a specific period, the Return on Equity and the Return on Average Equity numbers should be similar, or identical. Calculation (formula) ROAE = Net Income / Avg Stockholders' Equity The return on average equity is a financial ratio that measures the profitability of a company in relation to the average shareholders equity. This financial metric is expressed in the form of a percentage which is equal to net income after tax divided by the average shareholders equity for a specific period of time. The main steps involved in the computation of Return on average equity are: 1. Establish the balance sheet or the Statement of Shareholder s Equity. After doing this, obtain the common shareholders equity for the most recent year (CSE 1) and also the same for previous year (CSE 2). 2. Compute the average common shareholders equity (AvgCSE) for the current year and the previous year. 104

23 3. Find out the Net Income for the year for which the ROAE is to be estimated. The net income can be found near the foot of the income statement for the current year. 4. As a final point, compute the Return on Average Equity. Return on Equity (ROE) Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. ROE is one of the most important financial ratios and profitability metrics. It is often said to be the ultimate ratio or the mother of all ratios that can be obtained from a company s financial statement. It measures how profitable a company is for the owner of the investment, and how profitably a company employs its equity. Calculation (formula) Return on equity is calculated by taking a year s worth of earnings and dividing them by the average shareholder equity for that year, and is expressed as a percentage: ROE = Net income after tax / Shareholder's equity Instead of net income, comprehensive income can be used in the formula's numerator (see statement of comprehensive income). Return on equity may also be calculated by dividing net income by the average shareholders' equity; it is more accurate to calculate the ratio this way: ROE = Net income after tax / Average shareholder's equity Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at the period's end and dividing the result by two. A common way to break down ROE into three important components is the DuPont formula, also known as the Strategic Profit model. Splitting the return on 105

24 equity into three parts makes it easier to understand the changes in ROE over time. Norms and Limits Historically, the average ROE has been around 10% to 12%, at least in the US and UK. For stable economics, ROEs more than 12-15% are considered desirable. But the ratio strongly depends on many factors such as industry, economic environment (inflation, macroeconomic risks, etc.). The higher ROE is better. But a higher ROE does not necessarily mean better financial performance of the company. As shown above, in the DuPont formula, the higher ROE can be the result of high financial leverage, but too high financial leverage is dangerous for a company's solvency. Return on Invested Capital (ROIC) ROIC is the capital which is return on investment in business is a high-tech way of examining a stock at return on investment that corrects for some specialties of Return on Assets and Return on Equity. It is a valuable knowing that how to translate it because it s a better evaluation of profitability than Return on Assets and Return on Equity as the whole. Fundamentally ROIC mends on Return on Assets and Return on Equity because it places the liability and equity financing at a comparable footing. It gets rid of the debt related to aberration that can make extremely leveraged organizations look very productive when they using return On Equity. It also applies distinct definitions of Profits than Return on Equity and Return on Assets; both of these apply Net Profits. However, ROIC (returned on invested capital) applies Operating Profits subsequently deduction of taxes but earlier than interest expenses. The correct operating functioning of a company is best analyzed by ROIC, which examines all returns on all the capital which is invested in the company no matter of the origin of the capital. 106

25 Calculation (formula) Return on invested capital (ROIC) = Net operating profit after tax (NOPAT) / Capital Investment OR ROIC = (Net Income - Dividends) / Capital Investment The ROIC is commonly presented as a percentage. Its interpretation is similar to Return on Assets and Return on Equity ratios. Return on Investment (ROI) Return on investment (ROI) is performance measure used to evaluate the efficiency of investment. It compares the magnitude and timing of gains from investment directly to the magnitude and timing of investment costs. It is one of most commonly used approaches for evaluating the financial consequences of business investments, decisions, or actions. If an investment has a positive ROI and there are no other opportunities with a higher ROI, then the investment should be undertaken. A higher ROI means that investment gains compare favorably to investment costs. ROI is an important financial metric for: Asset purchase decisions (such as computer systems, machinery, or service vehicles) Approval and funding decisions for projects and programs of different types (for example marketing programs, recruiting programs, and training programs) Traditional investment decisions for example management of stock portfolios or the use of venture capital. Calculation (Formula) To calculate return on investment, the benefits (or returns) of an investment are divided by the costs of the investment. The result can be expressed as a percentage or a ratio. 107

26 Return on Investment (ROI) = (Gains from Investment Cost of Investment) / Cost of Investment It should be noted that the definition and formula of return on investment can be modified to suit the circumstances -it all depends on what is included as returns and costs. For example to measure the profitability of a company the following formula can be used to calculate return on investment. Return on Investment = Net profit after interest and tax / Total Assets Norms and Limits One drawback of ROI is that it by itself says nothing about the likelihood that expected returns and costs will appear as predicted. Neither does it say anything about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the expected results. Therefore, a good investment analysis should also measure the probabilities of different ROI outcomes. It is important to consider both the ROI magnitude and the risks that go with it. Return on Net Assets (RONA) The return on net assets (RONA) is a comparison of net income with the net assets. This is a metric of financial performance of a company that takes into account earnings of a company with regard to fixed assets and net working capital. The return on net assets (RONA) helps the investors to determine the percentage net income the company is generating from the assets. This ratio tells how effectively and efficiently the company is using its assets to generate earnings. This is an important ratio because in many companies the fixed assets are a single largest component of the investment. Although there are no fixed standards or benchmarks for RONA but the higher this ratio is the better it is. Higher RONA means that the company is using its assets and working capital efficiently and effectively. An increasing RONA is an indicator of improving profitability and improving financial performance of a company. 108

27 This ratio should usually be used in capital-intensive industries where major purchases are for fixed assets. It should be used in subsequent years to see how effective the investment in new fixed assets has been. Calculation (formula) The return on net assets (RONA) is calculated by dividing the net income of a company by the sum of its fixed assets and net working capital. This can be expressed in the following formula. Return on Net Assets = Net Income / (Fixed Assets + Net Working Capital) The figure for net income can be found in the income statement. Net income is also known as profit after tax. The figure for fixed assets can be found in the balance sheet. Fixed assets include property, plant and equipment, long term investments, and other non-current assets. The net working capital is defined as current assets minus current liabilities. Return on Retained Earnings (RORE) The return on retained earnings (RORE) is a calculation to reveal the extent to which the previous year profits were reinvested. The return on retained earnings is expressed as a percentage ratio. A higher return on retained earnings indicates that a company would be better off reinvesting the business. On the contrary, a lower return on retained earnings indicates that paying out dividends might prove to be in the company s best interests. It can generally, as an investor, be difficult to evaluate the worth of a company by just having a look at its balance sheet. A return on retained earnings computation can be helpful in assuaging some of the confusion in addition to clarifying unerringly what the numbers are trying to say. For investors, a general rule of thumb is to look for companies featuring a high return on retained earnings which is regularly reinvested. Estimating the return on retained earnings The main steps involved in computation of return on retained earnings are as listed below: 109

28 Establish a dividend policy. The dividend policy affects the return looked for by a company to earn on its retained earnings. External factors, counting additional financing and investment opportunities, are helpful in delineating the dividend policy. Besides, internal conditions, like shareholders tax position, previous year s dividends, and the liquidity of the company are also helpful in shaping the dividend policy. The next step is to achieve the confidence of the shareholders. Generally, the shareholders invest in a company with two basic aims earn regular dividends, and enjoy capital gains when they dispose of company shares. Alterations in dividend policy can be a warning signal for the shareholders thus making it essential for the investors to reassure that a decrease in dividend payments indicates the company s wish to make additional investments in the business. Thereafter, move ahead towards making additional investments. This requires investing time and money to research for adequate investment opportunities which are not able to earn the requisite return on shareholders investment. The final step is monitoring the company s performance, especially the return on retained earnings ratios. Besides, it is also essential to ensure that the company practices equilibrium between its profitability and liquidity. Risk-Adjusted Return It is a concept which measures the value of risk involved in an investment s return. It is of great importance because it enables the investors to make comparison between performance of a high risk, high risk investment return with less risky and lower investment returns. Risk adjusted return can apply to investment funds, portfolio and to individual securities. There are mainly five popular methods of calculating risk adjusted return such as Alpha, beta, r-squared, Sharpe ratio and standard deviation. Each of the method has its unique measures of risk, strengths and weaknesses and each has its own requirements for data like standard deviation and market performance, investment rate of return and risk free rate of return for a specific period. Investor can use any of calculation according to his choice. For comparison of two or 110

29 more investments, investor must use same risk measuring method for each investment to get relative performance results. Sharpe ratio is most widely used risk measuring tool. Through this method one can compute the expected return by potential impact of return volatility, the total earned amount of return on per unit of risk. An increase in Sharpe ratio of a fund means, its historic adjusted performance is better. An increase in number will bring an increase in return per unit of risk. formula is: (Portfolio return Risk free return) / Standard deviation of portfolio return Risk adjusted return varies from person to person depending on several factors like risk tolerance, financial resources, willingness for holding a position for a long time for market recovery in the event investor made a mistake, investors opportunity cost and tax condition. You can improve risk adjusted return by adjusting your stock position according to market volatility. An increase in volatility will decrease the equities position or vice versa. This strategy is really helpful to avoid big losses and to focus on significant gains. However one can never calculate exact risk adjusted return because of no specific rules. The basic phenomenon behind use of risk adjusted rate of return is that an investor can only rank them from lowest to highest in terms of attractiveness. PROFITABILITY RATIOS ANALYSIS OF SAMPLE UNITS OF REAL ESTATE There are many ratios under Profitability Ratios. Ratio analysis of sample units of real estate is done on the basis of a few of them only. 111