Introduction to financial ratios: profitability
Equity investors may have access to research reports and other market-related information like articles and models. However, the language used therein often comes across as very technical. It is important to have a basic understanding of certain key concepts (and jargon) to optimally utilise the information presented by the experts and to increase the value that these reports and articles provide. Although the use of financial ratios has its limitations, it can provide very useful insight into a company. Financial ratios aim to measure the relative and absolute strengths and weaknesses of a company. Analysts use this information to estimate the future profitability and sustainability of a business, as well as possible risks to cash flows and income. Ratio comparisons resulting in large deviations from the norm are only a symptom of a potential problem and further analysis of the firm’s financial statements, coupled with discussions with management, are generally required to isolate the cause of the deviation.
Making sense of financial ratios
Applying a formula to financial data to calculate a ratio is only the first step in making sense of financial statements. The more important step is the interpretation of these ratios. Almost none of them can be analysed on a stand-alone basis. To decide if a ratio is "too high or too low" or "good or bad", a benchmark is required.
Ratio categories
Different ratios will provide insight into different factors impacting the investment case for the company.
Important financial ratios
The more commonly used equity market ratios are covered in this section.
1. Return on Equity (ROE)
ROE measures the return earned on the owners' (shareholders) investment. The ROE of a company can be compared with industry peers as well as its own history - the higher the ROE, the better.
The Du Pont analysis is a more comprehensive way of calculating ROE, by dividing the calculation into the three variables that influence ROE. These are profitability (the net profit margin), activity (asset turnover) and leverage (also called gearing). This gives analysts a deeper understanding into the companies return on equity and where improvements can be made.
2. Return on net assets (RONA)
RONA is closely related to ROE and can be calculated as follows:
The return on assets shows how efficiently the company has utilised its assets to generate a profit. This clarifies redundant assets or lack of productive assets relative to industry norms as well as the company's own history. The higher the RONA, the better.
3. Market ratios
a) Earnings per share
EPS measures profit relative to each ordinary share in issue. It is usually carefully monitored by investment analysts and portfolio managers. It is important to consider business profits per share, as additional shares issued will lower the economic interest of a share and ultimately may have an impact on cash returns per share (like dividends).
The EPS does not represent the earnings distributed to shareholders. The earnings distributed to ordinary shareholders are reflected by the dividend per share. This ratio is useful when comparing it to the historical EPS of the company but may lose value when comparing it to other industry shares because companies generally don't have the same number of shares in issue.
b) Price-earnings (PE) ratio
The PE ratio is a very effective tool and a simple way for analysts and investors to determine the relative value of a share. It also makes it easy to compare the value of a company (as it relates to profitability) relative to its peers and its own history.
c) Headline Earnings:
Headline earnings account for all the profits and losses from operational, trading, and interest activities. Excluded in headline earnings are once-off profits or losses related to non-core income like the sale or termination of discontinued operations, fixed assets, or related businesses. Permanent devaluation and write offs are also excluded. This figure is used to compare and contrast companies without the sometimes-big profits and/or losses that are once-off occurrences and not part of ongoing income creating potential.
Analysts often use headline earnings per share (HEPS) to calculate PE's in order to make comparisons more valuable.
d) Dividend per share (DPS) and Dividend Yield (DY)
The dividend per share is the actual cash flow shareholders receive. It can also be expressed as a dividend yield or DY.
Dividends per share and dividend yields are important factors for income generating portfolios and investors that require a cash income from their investments, like pensioners. Consistent and high dividend yields are preferred for these investment objectives and can be compared to annual investment rates and other alternative investments.
DPS and DY do not measure the profitability of the company, but only the part of profits paid out to shareholders. It is also important to note that even though some companies pay dividends consistently, it is not compulsory like interest and coupon payments.
e) EBITDA - (Earnings Before Interest, Taxes, Depreciation and Amortisation)
EBITDA is not as daunting as the name implies. It effectively excludes all costs not directly related to the main operations of a company, being interest, taxes, depreciation, and amortisation. It is a good measure of a company's ability to make money out of its core business operations. Although interest, taxes, depreciation, and amortisation impact the net profitability of a firm, EBITDA reduces the financial noise down to a single number that represents core business operations income.
Analysts can make better comparisons of similar businesses in the same industries, as well as focus on how well the company is faring operationally.
4. The debt ratio (or debt-to-assets ratio)
The debt ratio measures the proportion of total liabilities relative to its total assets.
The higher this ratio, the more financial leverage the firm has. This figure is of particular importance during periods of rising interest rates. Higher interest rates result in higher interest on loans. This means that the firm will have to ensure that it generates sufficient cash to cover higher interest payments.
5. The debt-to-equity ratio
The debt-to-equity ratio illustrates the relationship between the long-term funds provided by creditors and those provided by the firm's owners. It is commonly used to measure the degree of financial leverage of the firm.
This figure is meaningful only if viewed against the background of the nature of the firm's business. Firms with large amounts of fixed assets, stable cash flows, or both, typically have high debt-equity ratios, while less capital-intensive firms, or firms with volatile cash flows, or both, tend to have lower debt-equity ratios. The industry average will generally provide a good basis for comparison of the debt-equity ratio.
How to use ratios and analysis reports effectively:
Financial market ratios and calculations can give a great amount of insight into the current position and prospects of a company. This presupposes the correct use and application of these variables.
