Decoding Profitability Ratios

Companies are in business for one purpose i.e. to make profits. If a company accumulates considerable losses year after year, it will not stay in business for long. Profits are the driving force of growth and also, the main source of repaying loans, making new investments along with providing an adequate return to owners so that they retain their interest and financial backing.

Profits are also important for another reason. They measure the relative success of a company and can readily be compared to other companies as well as to the capital market. Therefore, profits reflect (and profit ratios measure) the effectiveness and efficiency of the management. The common profitability ratios are:

• Return on sales
• Return on assets
• Return on equity

Return on sales

The return on sales ratio (profit on sales) measures how many rupees of profit are made for every Rs 100 in the net sales. The figure is calculated in percentage as:

ROS = (net income/net sales)*100

Let's compare the profits for Company A and Company B.

In the above table, we can see that Company A earned Rs 20 for every Rs 200 in sales, with a profit of 10 per cent. Profits earned by Company B were higher in monetary terms; but at 2.5 per cent of net sales and were proportionally lower than those earned by Company A. Therefore, Company A generates more income on each Re 1.00 in sales than Company B. This is an indication that Company A generates profit more efficiently.

Return on assets

Return on assets is a good indicator of the firm’s productivity and also, of management's abilities and efficiency. The index measures the relationship between profits and the total resources invested. It is computed in percentage terms as:

ROA = (net income/average assets) * 100

Since asset values vary during the year, the best measure is based on an average of beginning-of-year assets and end-of-year assets. Let's look at an example and compare the ratios calculated in two ways:

First, we calculate the return on assets based on the end-of-year assets only. For year 20XX, Rs 150/Rs 6,000 = 2.5 per cent.

The more accurate method is to calculate return on assets based on the average of beginning-of-year and end-of-year figures. For year 20XX, Rs 150/ [(Rs 4,000 + Rs 6,000) / 2] = 3.0 per cent.

However, as a practical matter, this ratio often is calculated based on year-end figures only. This avoids calculating the first year on a year-end basis and the subsequent years on an average basis since averages cannot be computed for the first year

Return on assets is best measured against prior period results from the same firm or against similar enterprises. The higher the result, the better, since a good return on assets indicates efficient use of the firm's resources.

Return on equity (or return on capital)

Return on equity (ROE) measures the profits generated by each dollar accumulated in business by the stockholders. The figure is computed in percentage terms as:

ROE = (net income/average net worth) * 100

Determining return on equity is important for measuring the degree to which the profits of the firm provide a return to the shareholders. The figure can be compared to a marginal investment rate in the community, such as a time deposit rate in a local bank. ROE measures whether the enterprise can produce an amount sufficient to cross this hurdle rate and provide an incentive to take on additional risks of equity investment.

Let's look at the difference between using only the ending balances and an average of the beginning and ending balance.

Using end balance only, for the year 2019, (Rs 60/Rs 2,400)*100 = 2.5 per cent.

Using average of the beginning and ending balance, for the year 2019, Rs 60/ [(Rs 2,000+Rs 4,000)/2] = 2.73 per cent.