How to measure business profitability

Is profitability the only measure to gauge a company’s performance? Making money is easy but what about how much capital the company is using to make money?

There are three ratios — Return on assets (ROA), Return on Equity (ROE) and Return on Capital employed (ROCE) — which show how good a company is at generating income from its resources.

Return on equity

Return on equity (ROE) is calculated by dividing net profit for the particular year by average shareholders’ equity, or ROE = Net profit/ Shareholder’s equity.

Equity here includes both paid-up capital and reserves. A high ROE indicates that the management is generating a better return for their shareholders.

If ROE is 25 then it indicates that Rs 25 of assets are created for every Rs 100 originally invested.

With ROEs for Indian companies declining in recent years, companies with high return on equity now enjoy higher valuations.

For example Colgate-Palmolive and Hindustan Unilever have ROE of 109 and 87, respectively, for FY12 and a PE of 44 and 36, respectively.

To track the growth trajectory of a company it is better to check the previous year’s ROE figure.

ROE rises if a company is able to re-invest its profits in the business to generate a higher return. If a company instead of investing the last year’s profit keeps it in reserves then despite a similar profit, its ROE would decline.

For example, if a company made a profit of Rs 100 and assume that equity including reserves is Rs 1,000, then ROE for this company is 10 per cent (100/1,000).

If the company maintains the same profit for the next year and therefore the last year’s profit will be added in the reserves and surplus and its ROE would decline to 9 per cent (100/1000+100).

To maintain same ROE it would have to generate a profit of Rs 110. A declining ROE indicates that new investments are not yet as profitable as the existing business.

ROE has its limitations and has to be analysed with other ratios. ROE can be increased by greater leverage.

Return on Assets

Return on Assets (ROA) is obtained by dividing net profit by total assets.

It indicates how much profit the company generates on its assets. It is always better to compare ROA of the same sector or with previous year performance.

It varies widely across different industries. It also depends on the capital intensity of the company, a company which requires large initial investments will generally have lower return on assets.

For example, Hindalco Industries, which is going through an expansion phase, has an ROA of 3.6 per cent whereas Nestle, which does not have any major capital expenditure, has an ROA of 24.4 per cent.

Return on Capital Employed

Return on Capital Employed (ROCE) is obtained by dividing operating profit after tax by a company’s capital employed. Capital employed here represents both equity and debt and is normally represented by subtracting current liabilities from total assets (or fixed assets plus working capital).

It has a few drawbacks. For example, due to depreciation, value of assets tends to decline for all companies.

Thus, ROCE may increase even though cash flow has remained the same. Bajaj Auto and Jubilant Food had one of the highest ROCE of 67 and 57 respectively for FY 2012.

Shaurya.mishra@thehindu.co.in