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Why Does A Company’s Profitability Matter To You – Part 3
Education | 29 August 2014
By: Peter Ng
Articles (81) Profile

The Journey So Far

Having previously discussed the two profitability measures, gross profit and operating profit margins, by now your competence in evaluating a company’s profitability would have levelled up by leaps and bounds.

To gear you up further, we shall include two other measures of profitability, return on equity (ROE) and return on assets (ROA).

Unlike gross profit and operating profit margins, ROE and ROA will involve another financial statement beyond the income statement to include the balance sheet. In addition, these measures would require a comparison with other similar companies in order to be used effectively.

By not including the balance sheet, it is as good as an investor who has made an investment with a blank cheque, but never knowing how much he has invested despite seeing returns.

The balance sheet provides valuable information on what a company owns and owes at a given point in time, therefore no profitability assessments can be complete without including measures on this financial statement.

Return On Equity

ROE is calculated by expressing net income over shareholders’ equity. This measure uncovers the amount of profit which a company is able to generate with its shareholders’ funds.

In other words, ROE provides a measure on how well or poor a company has utilised shareholders’ funds. A high ROE reveals that a company has more efficiently utilised shareholders’ funds to create economic returns for its shareholders compared to another with a lower ROE.

Also, since most companies retain a certain proportion of its profits as retained earnings, a high ROE could lead to higher amount of profits being retained which translates into more wealth being created for its shareholders.

This is clearly why Warren Buffett has mentioned that a formula for success is to seek out companies with high ROEs.

He stated further that companies posting high ROEs must lead to strong earnings growth, a steady increase in shareholders’ equity, a steady increase in the company’s intrinsic value, and ultimately a steady increase in share price.

"Focus on return on equity rather than earnings per share," Shareholder's letter of Berkshire Hathaway 1972

It is wise for an investor to investigate for the source of a company’s high ROE. That is, a high ROE could signal that a company has been aggressive towards funding its operations with debt.

As one might know, debt is a double-edged sword, it could harm a company on top of the benefits it provides. Therefore, a company with a high ROE that is fuelled by debt is a potential red flag.

Return On Assets

Noting a company’s assets are financed by debt or equity, therefore the value of its debt and equity combined equals to the assets which a company owns on its balance sheet.

Opposed to ROE which only takes into account of shareholders’ equity, ROA provides a measurement to assess a company’s ability in extracting profits from the assets it owns.

ROA is computed by dividing net income by total assets owned by a company.

A company with a higher ROA indicates that its management team is able to better and more effectively allocate its resources, earning a higher return with lesser amount of investment, compared to another similar company with a lower ROA.

For example, if Company A managed to earn a net income of $1 million on a total asset base of $10 million, compared to Company B which earned a net income of $10 million on an asset base of $200 million, Company A and B would register ROAs of 10 percent and 5 percent respectively.

Despite a lower amount of net income earned, Company A would have been better off than Company B.

This is because for every dollar invested, Company A is able to extract 100 percent more profits compared to B even though its ROA is only higher by 5 percentage points.

Putting Them Altogether

Finally, the combination of ROE and ROA provides indications on the effectiveness of a company’s management. A pair of high ROE and ROA is a strong sign that a company’s management team is performing up to speed in terms of generating returns for its shareholders, given that its debt level is in an acceptable range.

However, a high ROE matched with a low ROA could potentially mean that a company is carrying a significant amount of debt on its balance sheet. In this case, investors should be wary that the company’s high ROE is a result of an aggressive debt level, which as a result has distorted its ROE.

Backed by a strong interest in investments, Peter's research spans across a range of industries, with his focus placed on companies listed on the SGX.

Please click here for more information about this author.

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