6.2 Profitability, Return and Asset Turnover Ratios
Profitability:
Certainly, we are all interested in profitability. Each of the foregoing data (without the word “margin”) may be divided by “Total Sales” and used cross-sectionally or longitudinally. “Margin” means percentage. For example, gross profit margin = gross profits ÷ sales.
In discussing liquidity ratios, we agreed that in order to manage liquidity risk the current ratio should be at least one.We can also agree that too high a current ratio may be unhealthy. This is because current assets, especially cash, produce no return. Having inventory sitting around does no good.
A question to ask is: Why has the firm accumulated cash and other current assets rather than investing in more productive, fixed assets? There must be a balance between liquidity on the one hand, and return (see below) on the other. Too much of anything may not be good.
Even though the firm may have high profitability, it does not mean that its cash flow position is strong. One must also examine the solvency ratios, especially the TIE ratio. The company may have onerous obligations due to maturing debt and the need for replacement of long-term assets. A growing company may need a great deal of liquidity, in order to support growing sales, which growth would be reflected in growing inventory and accounts receivable. The analyst should also check the firm’s Liquidity.
Return Measures:
We will discuss two important return measures. These ratios give the analyst another look at profitability.
ROA = Return on Assets = EBIT ÷ TA
How well is a firm employing its assets? Return on Assets attempts to gauge this. While many will use net income in the numerator, EBIT is preferable in the sense that operating profits reflect what the assets produce, whereas net income is affected by the firm’s capital structure, i.e., interest expense and particularly taxes, and other possible items not directly associated with the firm’s actual business or “operations.”
ROA may be a good tool to judge management’s operating performance and its “asset utilization,” or how efficiently it exploits the firm’s assets. Why may two, otherwise identical companies, have different ROAs? Does one company manage better? Does it motivate its employees better? Are they better trained? Do they work harder or longer hours? Does it employ better technology?
ROE = Return on Equity = NI ÷ Equity
Common shareholders are most interested in ROE because that is what they get for their equity investment. They understand that for each dollar of equity invested, they will have a claim on the company’s net income, i.e., its dividends and (additions to) retained earnings.
What kind of return is the firm able to produce on its equity? Equity is the result of, not just the company’s past operating performance (EBIT) and its associated accumulation of retained earnings, but management’s capital structure decisions (i.e., the debt/equity ratio) when it had to raise capital in the past. The more debt there is, the less equity; the more interest expense, the less net income. EBIT also affects Net Income!
While ROA reflects the firm’s effectiveness in producing operating profits, or EBIT, the effective use of leverage, i.e., debt, can increase the firm’s ROE above its ROA. This is not guaranteed; borrowing does not ensure in all instances that ROE > ROA. In addition, “leverage,” i.e., the use of debt (OPM), increases the firm’s financial, or solvency, risk. We shall get a glimpse of this when we – soon – look into the DuPont model on the very next page. ROA and Leverage (i.e., the extent to which a firm utilizes debt) are inter-related. Stay tuned.
ROE may be a better tool (than ROA) for assessing a firm’s (equity) investment merits, because shareholders are most interested in net income as that will either be distributed to them as dividends and/or added to retained earnings, which are “owned” by shareholders.
Once again, what is management providing the shareholders for their equity investment? Shareholders are interested in earnings, as it is earnings, which are either paid out as dividends or retained, and that is what benefits the shareholders. Remember: retained earnings belong to the common shareholders.
Asset Turnover:
S ÷ Fixed Assets and S ÷ TA
Here “turnover” is not a physical concept as it was when we spoke about Inventory Turnover. How often do the firm’s Fixed Assets (i.e., Property, Plant, and Equipment),or total assets, “turn over” relative to sales? In other words, how much Sales does a company produce from its fixed or total assets? If two identical firms differ in only this respect, what might the analyst conclude? Does one firm maximize price and revenues? Does one firm manage production and exploit its assets more efficiently, more productively? What do turnover ratios say about pricing, asset utilization, and management performance?
An analyst may prefer using total assets rather than just fixed assets, in this analysis, if the company being analyzed is a service company with fewer fixed assets to speak of in comparison with a heavy manufacturing firm. An analyst may use Asset Turnover rather than Return Ratios in the case where EBIT = 0.
If you take shortcuts, you get cut short.
-Gary Busey, actor