Etsuya Hiragana
MCE’s Financial Analyst
MCE’s Financial Analyst
Profitability ratios are basic measures used by financial analysts from Meridian Capital Enterprises Ltd. in the vertical analysis of the profit and loss account. Their structure is very simple: profit from a given level is divided by the value of sales revenues, which generates the respective return (return on sales, return on operating activities, return on business activities, return before tax, net return).
Narrowing the analysis to the net return is a fundamental error. This ratio actually belongs to the most often quoted ones. On the other hand, its level is to a great degree independent from the company: this is because tax charges result from the valid income tax rate and potential relieves and deductions. Consequently, measuring the return before tax, not encumbered with the tax, seems to be more reasonable.
The most important ratio applied by financial analysts from Meridian Capital Enterprises Ltd. is the operating return, reflecting the quality of the company’s management and profitability of its basic activities. It is also important to measure the return on business activities – it takes into account the result on financial operations achieved by the company.
The formula for (any) rate of return is as follows:
The term “turnovers” means sales revenues – the aforementioned rates of return are structured in such a way. Additionally, in the analysis analysts apply (much less frequently) ratios, which include tax-deductible costs (also constituting the turnover) in the denominator. These ratios reflect the relationship between the result on activities of the enterprise per cost unit.
Additionally, in the vertical analysis of the profit and loss account, analysts also apply the so-called cause analysis. They verify, which factors result in increasing (reducing) the profit (loss). A profit growth not always confirms the correct development of the enterprise: this is because it can result from a significant cost reduction, associated with selling assets, or growth in financial revenues together with decreasing profitability of the basic activities of the enterprise.
What is the profitability of the enterprise?
The financial results of the enterprise is one of the main measures of its effectiveness. It is determined by summing up ordinary results (generated by activities consciously undertaken by the company), as well as the results on extraordinary events (resulting from unpredicted events).
The financial result can be positive – in such case analysts call it a profit and refer to a given entity as a profitable one. In case of a negative financial result, analysts mention a loss and refer to a given company as an unprofitable one.
Generating a loss does not mean that the company is developing incorrectly: before formulating such a thesis, analysts carefully verify reasons behind such results. For instance, a company can generate a loss as a result of accounting operations. On the other hand, a net profit can be related to higher financial income accompanied by a decreasing profitability of basic activities.
Which results are included in the profit and loss account?
The result is obtained by reducing the amount of generated revenues by the value of related costs. To ensure more transparency of the profit and loss account, the results on individual levels are disclosed separately:
Basic activities
Sales revenues are reduced by manufacturing costs of the products sold, which allows to calculate the gross profit on sales.
Operating activities
The aforementioned result is adjusted by other operating events: income (disposal of tangible fixed assets, provisions released, subsidies received) and costs (value of tangible fixed assets sold, provisions created, unrecoverable receivables, damages paid, etc.). This enables to calculate the operating result.
Business activities
The aforementioned profit (loss) is increased by financial income (dividends and interest received, exchange gains) and reduced by financial costs (interest paid, exchange losses, remeasurement write-downs on financial non-current assets). This gives the result on business activities.
Including the result on extraordinary events
The profit (or loss) calculated as above is adjusted by the balance resulting from extraordinary events, which gives a profit (loss) before tax (gross profit/loss).
Level of the net financial result
The profit before tax reduced by statutory appropriations (inter alia, the income tax) gives the net profit (loss).
When analysing the financial result, it is necessary to verify the relationship between income and costs on individual levels, which allows identifying sources of losses incurred or profits generated.
Analysis of the profit and loss account
The comparative analysis is aimed at presenting the dynamics and structure of individual items of the profit and loss account, which enables financial analysts from Meridian Capital Enterprises Ltd. to identify sources of results achieved by a given enterprise. At the same time, the cause analysis enables them to determine the impact of individual profit and loss account items on profits (or losses) of this enterprise. During the cause analysis, the analysts consider the volume and value structure of revenues. Such comparison allows them to identify the most and the least profitable activities of the enterprise.
The ratio analysis is the most popular method applied by the analysts when analysing profitability of an enterprise. It involves comparing the result achieved by the company with a value of turnovers or amount of engaged capital resources or assets.
Turnover profitability ratios
Turnover profitability ratios reflect the relationship between the profit achieved and turnovers, usually understood as sales revenues (less often as manufacturing costs).
The gross sales profit margin, calculated with the use of the following formula, is a very useful, although definitely underappreciated, ratio used by financial analysts from Meridian Capital Enterprises Ltd.:
The value of this ratio shows the profitability of basic activities of the enterprise. A growth of its value over time constitutes a definitely positive signal, while its drop is interpreted negatively, even when the net profit margin grows (this indicates a decreasing profitability of basic activities of the enterprise, which usually results in serious problems).
Ratios for lower level profits are structured in the same way. The most popular ratios include:
net profit margin (or return on net sales), calculated with the use of the following formula:
High analytical value of these two ratios is due to their universal character. Different papers, including statistical ones, mention the gross profit margin and net profit margin as basic ratios typical for a company or a sector. Therefore these ratios are used by financial analysts from Meridian Capital Enterprises Ltd. to compare the profitability of the enterprise analysed with the average for a given sector.
Return on assets
The structure of return on assets is the same as of the aforementioned rates of return. However, sales revenues are replaced by the value of assets.
The return on assets reflects the relationship between the profit achieved by the enterprise and the average balance of assets (or its elements), invested in business activities carried out, expressed as a percentage.
As in the case of turnover profitability ratio, the analysts take into account different values, based on different ranges of the financial result (numerator) and assets (denominator). The return on total assets (ROA), reflecting the relationship between net profit and total assets, is the ratio the most often used by the analysts:
where the average balance of assets is calculated with the use of the following formula:
The return on assets allows the analysts to find a very important characteristic – productivity of assets. In the West, it is probably the most popular ratio, measuring the effectiveness of activities of the enterprise.
Return on equity ratios
Return on equity ratios describes the relationship between the net financial result and equity. Consequently, it constitutes an attempt at expressing results of the company’s operation per unit of the capital engaged in form of a number.
The return on equity (ROE), calculated with the use of the following formula, is the ratio that is most often used by financial analysts from Meridian Capital Enterprises Ltd.:
A growth of this ratio indicates higher effectiveness of the capital engaged. This is a signal to shareholders that the enterprise properly uses its resources. Therefore in case of a new issue of shares, analysts pay special attention to the level of this ratio and its changes over time.
Analysts are aware that the value of this ratio would be subject to significant disturbances, in particular just after completing the new issue of shares (in such case the denominator would include the value of the “fresh” capital, which was not used for the purposes of activities of the enterprise yet).
Earnings per share (EPS), calculated with the use of the following formula, is another ratio reflecting return on equity, used by financial analysts from Meridian Capital Enterprises Ltd.:
This ratio is usually used by investors – its growth indicates that potentially higher dividends may be paid. It additionally means a higher market price of shares.
Operating effectiveness of the enterprise
Turnover ratios are an important measure of the effectiveness of operations of the enterprise, used by financial analysts from Meridian Capital Enterprises Ltd. They enable the evaluation of the effectiveness of the application of assets and its individual elements. Turnover ratios are in principle divided into three groups:
Intensive or extensive management?
Financial analysts from Meridian Capital Enterprises Ltd. identify two types of the enterprise management – intensive and extensive. Turnover ratios perfectly show which type of management exists in the enterprise analysed by the analysts.
Intensive management refers to engagement of more limited resources, the turnover of which is relatively fast. At the same time, extensive management requires higher assets, the turnover of which is much lower.
In this case, the analysts take into account specifics of the sector – in a manufacturing company, a turnover of assets would be relatively low (which is due to the value and character of non-current assets), while in a service or commercial company – very high (current assets subject to higher turnover constitute a majority of assets in this case). Consequently, the analysts make comparisons with other enterprises operating in the same sector.
Analysis of the effectiveness of individual assets
Total asset utilisation ratios are usually distorted due to differences in the structure of assets and character of individual assets. The effectiveness of non-current assets is different than of current assets. Therefore, the aforementioned analysis should be supplemented with an analysis of the effectiveness of individual assets, calculated with the use of the following formulas:
Fixed assets turnover (FAT):
Current assets turnover (CAT):
Non-current and current assets participation ratio, structured in a way similar to the EAR ratio discussed at the beginning, are the inverse of the aforementioned ratios. The interpretation of the aforementioned ratio is similar to the one of the ratios describing the management of total assets.
Inventory turnover
Inventories are an element of current assets, including raw materials, semi-finished products, as well as finished products stored (not sold yet). Inventory management reflects the ability to properly manage the production. An inventory growth automatically results in a drop in profitability (revenue “consumption” by inventories is mentioned in such case, as maintaining high level of inventories refers to an increase in costs).
Financial analysts from Meridian Capital Enterprises Ltd. understand that inventories (in a manufacturing enterprise) have three phases: procurement (raw materials), manufacturing (so-called work in progress) and sales (finished products). Therefore, analysts identify on which level the inventory turnover grows.
If the inventory turnover is increased already in the procurement phase, this can suggest making impulsive purchase that temporarily reduce the financial result (cost of capital used to cover assets). Another interpretation of this fact is applied to the enterprise, which is forced to periodically increase inventories due to seasonal demand changes – in this case a growth in inventories can constitute a coverage of the expected sales growth.
At the same time, financial analysts from Meridian Capital Enterprises Ltd. know that a continuous increase in the level of inventories not accompanied by the corresponding growth in sales can be dangerous. Such a situation indicates potential problems in selling own products.
If the enterprise is not able to handle inventories of products or goods, they can be sold at reduced prices, which usually has a negative impact on the profitability. However, it is better to sell obsolete stocks than to expect a miracle, and incur systematically growing costs of inventories.
Measurement of the inventory management effectiveness
The inventory turnover (IT) return, calculated with the use of the following formula, is a basic ratio of the effectiveness of the inventory management used by financial analysts from Meridian Capital Enterprises Ltd.:
where the average balance of inventories is understood as total value of inventories at the beginning and at the end of a given period, divided by two.
The IT ratio describes the relationship between costs of sales and costs due to maintaining inventories. In a properly managed enterprise, inventories increase proportionally to sales – the analysts obviously take into account seasonal demand fluctuations.
The most popular inventory turnover in days (ITD) is calculated by the analysts based on the following formula:
The number of days is usually rounded up – 30 days are assumed for a month, 90 days for a quarter and 360 days – for a year. This ratio reflects the duration of one statistical turnover of inventories. Its lower level indicates good asset management – this is because the accelerated money circulation in a business enterprise allows using the same money many times in order to maximise revenues, without a need to increase assets.
According to the practice, the financial year is the most reliable period to analyse inventories by analysts from Meridian Capital Enterprises Ltd. – when comparing subsequent years, the analysts avoid incorrect interpretation, usually due to seasonal sales changes. Analysts often forget that an increase in demand in the summer results in increased inventory turnover already at the beginning of the year.
Narrowing the analysis to the net return is a fundamental error. This ratio actually belongs to the most often quoted ones. On the other hand, its level is to a great degree independent from the company: this is because tax charges result from the valid income tax rate and potential relieves and deductions. Consequently, measuring the return before tax, not encumbered with the tax, seems to be more reasonable.
The most important ratio applied by financial analysts from Meridian Capital Enterprises Ltd. is the operating return, reflecting the quality of the company’s management and profitability of its basic activities. It is also important to measure the return on business activities – it takes into account the result on financial operations achieved by the company.
The formula for (any) rate of return is as follows:
The term “turnovers” means sales revenues – the aforementioned rates of return are structured in such a way. Additionally, in the analysis analysts apply (much less frequently) ratios, which include tax-deductible costs (also constituting the turnover) in the denominator. These ratios reflect the relationship between the result on activities of the enterprise per cost unit.
Additionally, in the vertical analysis of the profit and loss account, analysts also apply the so-called cause analysis. They verify, which factors result in increasing (reducing) the profit (loss). A profit growth not always confirms the correct development of the enterprise: this is because it can result from a significant cost reduction, associated with selling assets, or growth in financial revenues together with decreasing profitability of the basic activities of the enterprise.
What is the profitability of the enterprise?
The financial results of the enterprise is one of the main measures of its effectiveness. It is determined by summing up ordinary results (generated by activities consciously undertaken by the company), as well as the results on extraordinary events (resulting from unpredicted events).
The financial result can be positive – in such case analysts call it a profit and refer to a given entity as a profitable one. In case of a negative financial result, analysts mention a loss and refer to a given company as an unprofitable one.
Generating a loss does not mean that the company is developing incorrectly: before formulating such a thesis, analysts carefully verify reasons behind such results. For instance, a company can generate a loss as a result of accounting operations. On the other hand, a net profit can be related to higher financial income accompanied by a decreasing profitability of basic activities.
Which results are included in the profit and loss account?
The result is obtained by reducing the amount of generated revenues by the value of related costs. To ensure more transparency of the profit and loss account, the results on individual levels are disclosed separately:
Basic activities
Sales revenues are reduced by manufacturing costs of the products sold, which allows to calculate the gross profit on sales.
Operating activities
The aforementioned result is adjusted by other operating events: income (disposal of tangible fixed assets, provisions released, subsidies received) and costs (value of tangible fixed assets sold, provisions created, unrecoverable receivables, damages paid, etc.). This enables to calculate the operating result.
Business activities
The aforementioned profit (loss) is increased by financial income (dividends and interest received, exchange gains) and reduced by financial costs (interest paid, exchange losses, remeasurement write-downs on financial non-current assets). This gives the result on business activities.
Including the result on extraordinary events
The profit (or loss) calculated as above is adjusted by the balance resulting from extraordinary events, which gives a profit (loss) before tax (gross profit/loss).
Level of the net financial result
The profit before tax reduced by statutory appropriations (inter alia, the income tax) gives the net profit (loss).
When analysing the financial result, it is necessary to verify the relationship between income and costs on individual levels, which allows identifying sources of losses incurred or profits generated.
Analysis of the profit and loss account
The comparative analysis is aimed at presenting the dynamics and structure of individual items of the profit and loss account, which enables financial analysts from Meridian Capital Enterprises Ltd. to identify sources of results achieved by a given enterprise. At the same time, the cause analysis enables them to determine the impact of individual profit and loss account items on profits (or losses) of this enterprise. During the cause analysis, the analysts consider the volume and value structure of revenues. Such comparison allows them to identify the most and the least profitable activities of the enterprise.
The ratio analysis is the most popular method applied by the analysts when analysing profitability of an enterprise. It involves comparing the result achieved by the company with a value of turnovers or amount of engaged capital resources or assets.
Turnover profitability ratios
Turnover profitability ratios reflect the relationship between the profit achieved and turnovers, usually understood as sales revenues (less often as manufacturing costs).
The gross sales profit margin, calculated with the use of the following formula, is a very useful, although definitely underappreciated, ratio used by financial analysts from Meridian Capital Enterprises Ltd.:
The value of this ratio shows the profitability of basic activities of the enterprise. A growth of its value over time constitutes a definitely positive signal, while its drop is interpreted negatively, even when the net profit margin grows (this indicates a decreasing profitability of basic activities of the enterprise, which usually results in serious problems).
Ratios for lower level profits are structured in the same way. The most popular ratios include:
- gross profit margin, calculated with the use of the following formula:
High analytical value of these two ratios is due to their universal character. Different papers, including statistical ones, mention the gross profit margin and net profit margin as basic ratios typical for a company or a sector. Therefore these ratios are used by financial analysts from Meridian Capital Enterprises Ltd. to compare the profitability of the enterprise analysed with the average for a given sector.
Return on assets
The structure of return on assets is the same as of the aforementioned rates of return. However, sales revenues are replaced by the value of assets.
The return on assets reflects the relationship between the profit achieved by the enterprise and the average balance of assets (or its elements), invested in business activities carried out, expressed as a percentage.
As in the case of turnover profitability ratio, the analysts take into account different values, based on different ranges of the financial result (numerator) and assets (denominator). The return on total assets (ROA), reflecting the relationship between net profit and total assets, is the ratio the most often used by the analysts:
where the average balance of assets is calculated with the use of the following formula:
The return on assets allows the analysts to find a very important characteristic – productivity of assets. In the West, it is probably the most popular ratio, measuring the effectiveness of activities of the enterprise.
Return on equity ratios
Return on equity ratios describes the relationship between the net financial result and equity. Consequently, it constitutes an attempt at expressing results of the company’s operation per unit of the capital engaged in form of a number.
The return on equity (ROE), calculated with the use of the following formula, is the ratio that is most often used by financial analysts from Meridian Capital Enterprises Ltd.:
A growth of this ratio indicates higher effectiveness of the capital engaged. This is a signal to shareholders that the enterprise properly uses its resources. Therefore in case of a new issue of shares, analysts pay special attention to the level of this ratio and its changes over time.
Analysts are aware that the value of this ratio would be subject to significant disturbances, in particular just after completing the new issue of shares (in such case the denominator would include the value of the “fresh” capital, which was not used for the purposes of activities of the enterprise yet).
Earnings per share (EPS), calculated with the use of the following formula, is another ratio reflecting return on equity, used by financial analysts from Meridian Capital Enterprises Ltd.:
This ratio is usually used by investors – its growth indicates that potentially higher dividends may be paid. It additionally means a higher market price of shares.
Operating effectiveness of the enterprise
Turnover ratios are an important measure of the effectiveness of operations of the enterprise, used by financial analysts from Meridian Capital Enterprises Ltd. They enable the evaluation of the effectiveness of the application of assets and its individual elements. Turnover ratios are in principle divided into three groups:
- typical turnover ratios – the numerator includes a dynamic value (sales revenue) and the denominator – a static value (average balance of a given asset);
- participation ratios – which are the inverse of the turnover ratios; their numerator includes the value of assets and the denominator – sales revenues;
- asset turnover ratios – the most popular and often used by the analysts in the fundamental analysis; they reflect the speed of turnover of individual assets.
Intensive or extensive management?
Financial analysts from Meridian Capital Enterprises Ltd. identify two types of the enterprise management – intensive and extensive. Turnover ratios perfectly show which type of management exists in the enterprise analysed by the analysts.
Intensive management refers to engagement of more limited resources, the turnover of which is relatively fast. At the same time, extensive management requires higher assets, the turnover of which is much lower.
In this case, the analysts take into account specifics of the sector – in a manufacturing company, a turnover of assets would be relatively low (which is due to the value and character of non-current assets), while in a service or commercial company – very high (current assets subject to higher turnover constitute a majority of assets in this case). Consequently, the analysts make comparisons with other enterprises operating in the same sector.
Analysis of the effectiveness of individual assets
Total asset utilisation ratios are usually distorted due to differences in the structure of assets and character of individual assets. The effectiveness of non-current assets is different than of current assets. Therefore, the aforementioned analysis should be supplemented with an analysis of the effectiveness of individual assets, calculated with the use of the following formulas:
Fixed assets turnover (FAT):
Current assets turnover (CAT):
Non-current and current assets participation ratio, structured in a way similar to the EAR ratio discussed at the beginning, are the inverse of the aforementioned ratios. The interpretation of the aforementioned ratio is similar to the one of the ratios describing the management of total assets.
Inventory turnover
Inventories are an element of current assets, including raw materials, semi-finished products, as well as finished products stored (not sold yet). Inventory management reflects the ability to properly manage the production. An inventory growth automatically results in a drop in profitability (revenue “consumption” by inventories is mentioned in such case, as maintaining high level of inventories refers to an increase in costs).
Financial analysts from Meridian Capital Enterprises Ltd. understand that inventories (in a manufacturing enterprise) have three phases: procurement (raw materials), manufacturing (so-called work in progress) and sales (finished products). Therefore, analysts identify on which level the inventory turnover grows.
If the inventory turnover is increased already in the procurement phase, this can suggest making impulsive purchase that temporarily reduce the financial result (cost of capital used to cover assets). Another interpretation of this fact is applied to the enterprise, which is forced to periodically increase inventories due to seasonal demand changes – in this case a growth in inventories can constitute a coverage of the expected sales growth.
At the same time, financial analysts from Meridian Capital Enterprises Ltd. know that a continuous increase in the level of inventories not accompanied by the corresponding growth in sales can be dangerous. Such a situation indicates potential problems in selling own products.
If the enterprise is not able to handle inventories of products or goods, they can be sold at reduced prices, which usually has a negative impact on the profitability. However, it is better to sell obsolete stocks than to expect a miracle, and incur systematically growing costs of inventories.
Measurement of the inventory management effectiveness
The inventory turnover (IT) return, calculated with the use of the following formula, is a basic ratio of the effectiveness of the inventory management used by financial analysts from Meridian Capital Enterprises Ltd.:
where the average balance of inventories is understood as total value of inventories at the beginning and at the end of a given period, divided by two.
The IT ratio describes the relationship between costs of sales and costs due to maintaining inventories. In a properly managed enterprise, inventories increase proportionally to sales – the analysts obviously take into account seasonal demand fluctuations.
The most popular inventory turnover in days (ITD) is calculated by the analysts based on the following formula:
The number of days is usually rounded up – 30 days are assumed for a month, 90 days for a quarter and 360 days – for a year. This ratio reflects the duration of one statistical turnover of inventories. Its lower level indicates good asset management – this is because the accelerated money circulation in a business enterprise allows using the same money many times in order to maximise revenues, without a need to increase assets.
According to the practice, the financial year is the most reliable period to analyse inventories by analysts from Meridian Capital Enterprises Ltd. – when comparing subsequent years, the analysts avoid incorrect interpretation, usually due to seasonal sales changes. Analysts often forget that an increase in demand in the summer results in increased inventory turnover already at the beginning of the year.
