Profitability and Return

(A) Profitability

A company ought of course to be profitable and obvious checks on profitability are:

• Whether there is profit or loss on its ordinary activities
• By how much this year’s profit or loss is bigger or smaller than last year’s profit or loss.

(B) Return on Capital

It is important to assess profits or profit growth by relating them to the amount of funds (the capital) employed in making the profits.

Return on Capital Employed (ROCE) is an important profitability ratio. It is a ratio which states the profit as a percentage of the amount of capital employed.

Profit is taken as profit on ordinary activities before interest and taxation (PBIT) and capital employed is shareholders’ capital plus long-term liabilities and debt capital (or total assets less current liabilities).

ROCE = PBIT/ Capital employed

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Evaluating ROCE

There are three comparisons that can be made:

(a) Change in ROCE from one year to the next

(b) ROCE being earned by other companies, if this information is available.

(c) A comparison of ROCE with current market borrowing rates:

a. If the company needs more loans, what would be the cost of extra borrowing to the company? Is it earning an ROCE that suggests it could make higher profits to make such borrowing worthwhile?
b. Is the company making an ROCE which suggests that it is making profitable use of the current borrowing?

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Analyzing Profitability and ROCE in more detail: the secondary ratios

We may analyze the ROCE to find out why it is high or low, or better or worse than last year.

(a) Profit margins

A company that makes a profit of 25c per $1 of sales is making a bigger return on its turnover than another company making a profit of only 10c per $1 of sales.

(b) Assets turnover

It is a measure of how well the assets of a business are used to generate sales. For example Company A & B each have a capital employed of $100,000. Company A makes sales of $400,000 a year whereas company B makes sales of only $200,000 a year, company A is making a higher turnover from the same amount of assets. This will help company to make a higher ROCE than company B.

Profit margin and Asset turnover together explain the ROCE. The relationship between the three ratios is as follows:

PBIT/Sales x Sales/Capital employed = PBIT/Capital employed

It is also worth commenting on the change in turnover from one year to the next. Strong sales growth will usually indicate volume growth as well as turnover increases due to price rises. Volume growth is one sign of a prosperous company.


(source: BPP Learning Media)



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