Chapter 10

Profitability andReturn on Investment

Financial Information Analysis 2Copyright 2006 John Wiley & Sons Ltd

Profitability and Return on Investment

• Investments are made with a view to:• earnings• capital appreciation

• Investors will assess investment under:• profitability• return on investment• dividend policy• capital appreciation

• Ratios, etc. developed to assess these

Financial Information Analysis 3Copyright 2006 John Wiley & Sons Ltd

Profitability

• Critical for long-term viability• Gross Profit rate

• (Gross Profit / Revenue) x 100%• focus on trading activity• inter-company comparison

• Operating Profit rate• (Operating Profit / Revenue) x 100%

• Net Profit rate• (PBIT / Revenue) x 100%

Financial Information Analysis 4Copyright 2006 John Wiley & Sons Ltd

Return on Investment

• Relationship between investment & earnings

• Numerator (Earnings) must be consistent with denominator (Investment)

• Return on Capital Employed (ROCE):

• (PBIT / Capital Employed) x 100%

• Capital Employed usually long-term funding

• Denominator can also include short-term debt

• ROCE = Net Profit Rate x Asset Turnover

Financial Information Analysis 5Copyright 2006 John Wiley & Sons Ltd

Return on Investment ctd.

• Return on Equity (ROE) • focus on return enjoyed by owners

• i.e. denominator is Equity (Shareholders Funds)

• numerator changes to reflect this, i.e., profit after interest, tax and preference dividends

• ROE = • Profit after interest, tax and preference dividends.

Equity (Shareholders Funds)

Financial Information Analysis 6Copyright 2006 John Wiley & Sons Ltd

Earnings Per Share (EPS)

• Widely used and closely regulated• EPS = Earnings / Equity shares in issue• Must be provided at end of Income

Statement with workings in Notes• IAS 33: Basic and Diluted EPS• Calculation of denominator complicated

by:• new issues• share options

Financial Information Analysis 7Copyright 2006 John Wiley & Sons Ltd

Market ratios

• Price/Earnings Ratio (PER)• relationship between earnings and market price• important benchmark - industry averages available• = market price per share / EPS

• Earnings yield inverts this ratio• = EPS / market price per share• measures earnings generated in relation to market

price• Widely used by investors:

• Higher PER = expectation of EPS growth• PEG = PER/Prospective growth in EPS

• Prospective growth based on various assumptions

Financial Information Analysis 8Copyright 2006 John Wiley & Sons Ltd

Payouts

• Investors invest to earn a return• Total Shareholder Return:

• = Share price appreciation + Dividends

• Increasingly companies also engaged in Share Buybacks• Involves company acquiring own shares in

market

• Benefits for both shareholder and company• Occasionally used to favourably impact ratios

• Attractive to companies with cash surplus

Financial Information Analysis 9Copyright 2006 John Wiley & Sons Ltd

Dividend Policy

• Company dividend policy depends on:• previous policy• availability of profits and cash• market expectations

• Dividend Yield• (Dividend per share/Market Price per share) x

100%• Dividend Cover

• Profit after Tax and Pref Dividend / Ordinary Dividend

• Dividend Payout• Ordinary Dividend/ Profit after Tax and Pref

Dividend

Financial Information Analysis 10Copyright 2006 John Wiley & Sons Ltd

Summary

• Businesses must generate returns• profits• capital appreciation

• Ratios developed to assess earnings/return• relate earnings to investment being assessed

• Profitability ratios assess success of firm in generating profits

• Earnings ratios assess performance of firm from perspective of investors