Understanding Fundamental Analysis & Financial Ratios- II: Profitability

Financial Ratios for Accurate Fundamental Analysis

Welcome back to the second instalment of our blog series on fundamental analysis! In our previous article, we delved into the world of valuation multiples and how they serve as invaluable tools for assessing a company’s overall worth. Now, armed with a foundational understanding of these metrics, it’s time to journey deeper into the realm of financial analysis.

While valuation multiples provide a glimpse into a company’s market value, they are only a part of the comprehensive fundamental analysis puzzle. To complete the picture, we need to turn our attention to the company’s ability to generate profits, manage costs, and create value for its stakeholders. This is where a range of financial ratios focused on profitability comes into play. In this edition, we will unravel the intricate web of profitability, a crucial aspect that shapes the destiny of every company. So, let’s begin.


What is EPS?

First off on the list is EPS. EPS stands for “Earnings Per Share”. It is used to evaluate a company’s profitability and its ability to generate earnings for its shareholders- basically representing the company’s net profit in per-share terms. EPS is calculated by dividing a company’s net earnings (profits) by the number of outstanding equity shares. EPS is also an essential component in the calculation of the price-to-earnings (P/E) ratio, which is a widely used valuation metric.

How to Use EPS?

  • EPS is a key indicator of a company’s profitability. You use EPS to compare a company’s earnings performance over different periods and to compare it to other companies in the same industry. A higher EPS generally indicates better profitability, while a lower EPS may suggest a weaker performance.
  • You can consider a company’s EPS along with other financial metrics to gauge its financial health and growth potential. A company with a consistent track record of increasing EPS over time is a company worth looking into.
  • EPS allows you to compare the earnings of different companies on a per-share basis, regardless of their size or the number of outstanding shares. This comparison provides valuable insights into how efficiently a company is utilising its resources to generate profits.


Limitations of EPS

Be aware of potential dilution that can impact EPS. Companies may issue convertible bonds, employee stock options, convertible preferred stocks, warrants, etc., which can reduce EPS even if the overall profitability remains constant. For companies that have a large proportion of convertible securities in their balance sheet, diluted EPS can be used for a more accurate picture. Also, pay attention to non-recurring or extraordinary items that might significantly impact earnings. These items, such as restructuring costs or gains/losses from the sale of assets, can distort EPS figures and make them less reflective of the company’s ongoing performance.


What is the EBITDA Margin?

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) Margin is a financial metric that provides insight into a company’s operational profitability. It measures the proportion of a company’s revenue that translates into EBITDA, which is a measure of operating earnings before certain non-cash expenses and financial factors are considered. EBITDA Margin is often used as a key indicator of a company’s operational efficiency and financial health.

Formula: EBITDA Margin = (EBITDA/Total Revenue​) × 100

How to Use EBITDA Margin?

  • A higher EBITDA Margin suggests that the company’s core operations are generating healthy profits relative to its revenue.
  • EBITDA margin can help you understand how much the company is keeping for each rupee of revenue it generates on an operating level. More importantly, it enables comparisons between companies in the same industry or across industries and allows you to set a benchmark. Comparing the margin across time periods for the company can also help you gather good insights.


Limitation of EBITDA

It is important to remember that the EBITDA margin falls short of fully assessing a company’s financial health due to its exclusion of debt and interest costs. This can lead to potential inflation of profitability by high-leverage firms and overshadow true profitability.

Net Profit Margin

What is PAT Margin?

In contrast to the EBITDA margin’s focus on operational performance, the Net Profit Margin, also known as Profit After Tax (PAT) margin, delves into ultimate profitability. While the EBITDA margin solely considers operating expenses, omitting factors like depreciation, finance costs, and taxes, the Net Profit Margin accounts for all expenses. By deducting these expenses from Total Revenues, the PAT margin unveils a company’s comprehensive financial success. Expressed as the ratio of Net Profit After Tax to Total Revenues, the PAT margin provides a clear picture of a company’s overall profitability, encapsulating all factors influencing its final financial standing.

How to Use PAT Margin?

  • The PAT margin provides insights for strategic decision-making. A consistently declining PAT margin might signal operational inefficiencies, warranting cost-cutting measures or process improvements. Conversely, a rising PAT margin might indicate successful cost management, effective pricing strategies, or revenue growth.
  • When evaluating similar companies, the PAT margin offers a standardized measure to compare their relative profitability regardless of capital structure, tax regime, or accounting methods. A higher PAT margin generally indicates better profitability.


Limitation of PAT Margin

Be aware that one-off events like asset sales or extraordinary items can artificially inflate profits, leading to a temporary distortion in the margin. The net profit margin is most effective when used in conjunction with the EBITDA margin, providing a more nuanced understanding of a company’s performance.

Return on Equity

What is ROE?

Return on Equity (ROE) holds significant importance in investment analysis, offering insights into how effectively a company generates returns for its shareholders’ invested capital. This crucial ratio quantifies the entity’s capacity to derive profits from the funds provided by you. In essence, ROE serves as a measure of the company’s efficiency in translating investments into profits for its investors.

ROE = Net Income / Shareholders’ Equity

How to Use ROE?

  • A higher ROE is favourable as it signifies that more returns are being generated out of the shareholder’s capital.
  • Understand that whether an ROE is favourable or not depends on industry norms. Different sectors exhibit varying levels of asset utilization and capital structure. Compare the company’s ROE against its peers within the same industry to gain a relative perspective.
  • Analyze ROE over several years to identify trends. Consistent improvement or deterioration could signify evolving management practices, operational efficiency, or financial health.


Limitation of ROE

Remember that an elevated ROE doesn’t always signal strength; it could indicate inconsistent profits or excessive debt. Fluctuating ROE might highlight the irregular use of accounting methods.

Return on Assets

What is ROA?

Return on Assets (ROA) gauges a company’s ability to generate profits from its total assets. This metric evaluates the efficiency with which a company uses its assets to generate earnings. ROA is computed by dividing the company’s net income by its total assets and is expressed as a percentage. While ROE centres on the return earned for each unit of shareholders’ equity, ROA measures how efficiently a company utilises its assets to generate profits.

How to Use ROA?

  • A higher ROA signifies effective asset utilisation and better profitability, while a lower ROA might indicate inefficient asset management or lower profitability.
  • Analyse the trend of ROA over time. Consistent improvement or deterioration can indicate shifts in operational efficiency, changes in management strategies, or industry dynamics. A declining ROA might signify deteriorating asset utilisation, while a rising ROA could indicate improved profitability.
  • Compare ROA with industry peers to understand how the company’s asset utilisation stacks up against competitors. Industries with similar asset requirements often have comparable ROA benchmarks.


Return on Capital Employed

What is ROCE?

ROCE evaluates how effectively a company generates returns from its total capital investment, including both equity and debt. It measures the profitability of a company’s operations relative to the total capital it uses, representing a broader picture of efficiency in utilizing all sources of funding– this is also the primary difference between ROCE and ROE calculations.

​ROCE= EBIT​/Capital Employed

Capital Employed = Total Assets – Current Liabilities

How to Use ROCE?

  • ROCE reveals how efficiently a company generates returns from both equity and debt capital. A higher ROCE suggests the effective utilisation of all forms of capital to generate profits, making it a key indicator of operational efficiency.
  • Compare the company’s ROCE with its industry peers to understand its relative performance. This helps assess whether the company is utilising capital more effectively than its competitors, which can indicate a competitive advantage.
  • Analyze the trend of ROCE over time to identify consistency or fluctuations. A consistent or improving ROCE might indicate effective long-term capital management and
  • Operational performance.


Limitation of ROCE

Remember that a high ROCE could be influenced by aggressive borrowing, potentially masking financial risk. Also, like any other financial ratios, comparing ROCE across industries might be misleading due to varying capital requirements.

Thank you for joining us on this insightful journey exploring profitability ratios and their significance in assessing a company’s financial health. We hope that this blog has shed light on the importance of these metrics in determining a company’s profitability and potential for investment. As we continue our series on financial ratios, we invite you to stay tuned for our upcoming and last blog in this series, which delves into analysing the financial strength of a company. Understanding a company’s financial strength is crucial in gauging its resilience and strength to tackle financial storms in the future.

If you have a question, share it in the comments below or DM us or call us – +91 9051052222. We’ll be happy to answer it.

~ Dimensions, Nischay Avichal

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