Profitability Ratios- Fundamental Analysis

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Profitability Ratios

Profitability Ratios measures the ability of a business to generate income/earning relative to the expenses incurred by it during a particular period. These Ratios tell us how well a company utilizes its assets to generate value to its shareholders.

Profitability ratios can be used to judge whether companies are making enough operational profit from their assets. They relate to efficiency ratios because they show how well companies are using their assets to generate profits. Profitability is also important to the concept of solvency and going concern for the company.

A higher ratio or value means the business is performing well by generating revenues, profits, and cash flow.

In this article we cover “Return Ratios”

These ratios mainly focus on the company’s return on investment in inventory and other assets.

  1. Return on Assets:

The ratio specifically reveals how much after-tax profit a company generates for every one rupee of assets it holds. It also measures how much business as asset is able to generate. The lower the profit per rupee of assets, the more asset-intensive a company is considered to be. Highly asset-intensive companies require big investments to purchase machinery and equipment in order to generate income. Examples of industries that are typically very asset-intensive include telecommunications services, car manufacturers, and railroads. Examples of less asset-intensive companies are advertising agencies and software companies.

 

Below table shows the Return on Assets Ratio of HDFC and ICICI bank:

2014 2015 2016 2017 2018
HDFC 1.72 1.73 1.73 1.68 1.64
ICICI 1.64 1.72 1.34 1.26 0.77

 

We notice- that for both HDFC and ICICI the return on assets in the recent year has declined, but for  2018 ICICI bank’s return and way lower when compared to HDFC.

  1. Return on Equity:

It’s the the rate of return on the money that equity investors have put into the business. It measures the ability of a firm to generate profits from its shareholders investment made into the business.

A favourably high ROE ratio is can be seen as a reason to purchase a company’s stock. Companies with a high return on equity are usually more capable of generating cash internally and therefore are less dependent on debt financing.

Below table shows the Return on Equity Ratio of HDFC and ICICI bank:

2014 2015 2016 2017 2018
HDFC 19.50 16.47 16.91 16.26 16.45
ICICI 13.39 13.89 11.19 10.11 6.63

 

We notice- that though the return on equity for both the banks has declined sharply from 2014, but HDFC bank still keeps it almost stable from 2015 onwards giving us a return of 16% year on year, as opposed to ICICI which continues to fall.

  1. Return on Capital Invested:

Measures the return generated by all the capital that is employed within the firm- i.e. Debt and Equity. This is a long-term profitability ratio because it gives us a picture of how well the assets of a firm are being used to generate profit while taking into consideration the long-term financing. It helps in gauging the longevity of the company.

Income before deducting Interest rate is called ‘Net Operating Profit’ and Capital Employed is the shareholder’s equity less longterm liabilities.

Points to remember:

  1. Profitability Ratios measures the ability of a firm to achieve profits from its operations.
  2. Return Ratios measures the ability of a firm to generate returns to its shareholders.
  3. A higher ratio commonly means that the firm is performing well and is able to generate profits. It’s more useful in comparing two peer firms and gauging its return.

 

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