Imagine there are 2 companies, Banana and Sahara. Banana made $1 million last year and Sahara made $2 million. Which of these 2 companies is better? .You'd probably say "Sahara" right away, with a roll of the eyes too. "Isn't t obvious?" you might think. But what if I tell you that Banana used $5 million to make this 1 million while Sahara used $25 million to make the $2 million. Which company is better now? Well...
By this example, you probably realize it is as important to see how much money the company uses to generate profit as it is to see the profit itself. So looking at profitability of companies in isolation might not give you a good picture about the company's performance without looking at how much the company puts in to generate those returns. In the example above, if we had used a ratio of profit to capital employed by the company to compare the two, we would have found something like this:
Banana= $1 million/$5 million * 100% = 20%
Sahara = $2 million/ $25 million * 100% = 8%
Your decision to choose between these 2 companies just got a whole lot easier, considering all other things equal. Return ratios do exactly this.
So what are return ratios?
As the name suggests, these ratios are used to check how efficiently the company generate returns and thow well they are able to manage their money. Companies use their share capital or debt or assets to generate their profits. So different return ratios use different parts of a company's capital structure like its assets, debt, equity, etc. to assess how well the company manages those different types of capital that they have.
What are the types of return ratios?
There are 4 most widely used and important return ratios:
Return on equity (ROE)
Return on invested capital (ROIC)
Return on assets (ROA)
Return on capital employed (ROCE)
They all sound pretty similar and for a given company, they are usually all good or all bad. But they all have a different denominator. So each ratio shows how well a company manages that part of its capital structure and how well it can make money with what it has. So let us look at what each one means and how you can use them for your fundamental analysis.
Return on equity (ROE):
When you buy shares of a company, you become its shareholder and own the "equity" of the company. So return on equity is the first thing to look at as a shareholder since it tells you how much money the company makes with its equity. So it is basically the money a company generates with every dollar the shareholders have put in the company.
ROE (in %) = Net profit / Shareholders' equity * 100%
Because equity is assets - liabilities, ROE is also known as Return on net assets.
If you read my articles on how to read an income statement and how to read a balance sheet, you will easily remember that net profit can be seen from the income statement and shareholders' equity from the balance sheet. (You may take equity at the beginning and end of the year and use the average). Divide the former from the latter and you have the ROE of the company for that year.
Higher the ROE, the better. Duh! You want your company to make as much money as possible from the money put in by shareholders.
Compare with companies in the same sector for better analysis.
Consistency is key. Any company that is consistently making more than 20% ROE each year is worth your time.
Pro-tip: High ROE is good but too high ROE may not be. ROE may increase because the profits increased which is a good thing. But it may also be very high because of less equity. This may happen because the company has very high debt (after all equity = assets - debt) or it may have consistent losses which actually take out money from the "retained earnings" section of the equity. This is also why we need more than 1 ration to assess the company entirely.
Return on invested capital (ROIC):
Now that we realize that only using equity for our ratio keeps us blind to the debt part, we use ROIC to correct the problem. ROIC is similar to ROE but instead of using only equity, it uses the "invested capital" in the denominator. As we know, the company gets capital either from equity or debt. So here, we use equity + debt to calculate the "invested capital".
But isn't equity + debt = assets? Wouldn't the denominator be assets then? Isn't the ratio same as return on assets?
The catch here is that we only want to consider the "invested capital" of the company. So even though a company has many assets, if they have not been used to generate profits, they don't show up here.
So how to calculate "invested capital"?
Since we wish to find only the "invested capital" and not the total assets, we need to subtract from the assets column "cash and cash equivalent" which hasn't been invested in the company's operations. Since assets = debt + equity, we can also do this by adding debt and equity and subtract "cash and cash equivalent" from that.
Another important change in this formula is the profits in the numerator is actually NOPAT (Net Operating Profits after tax) and not Net Profits.
NOPAT is basically EBIT (Earnings before Interest and Tax) * (1- Tax rate). So basically NOPAT is profits after paying taxes but without considering the interest payment.
So, if a company has a NOPAT of $1000 but an interest payment of $1000 as well, it looks non-profitable. But the company is actually profitable in its operations and it may be reducing its debt as well. So NOPAT gives a clearer picture about the company's operational profitability.
ROIC (in %) = NOPAT / Invested capital * 100%
Higher the ROIC, the better.
Generally, the ROIC is compared to WACC (Weighted average Cost of Capital) which is basically the cost company pays to raise money through equity and debt. Say, for example, a company has not sold its shares to anyone, with 100% equity with the founder, but it took a debt on an interest of 12% to start its operations. Now, the ROIC will only be with respect to the loan amount raised. If the company is able to generate a return of 14% on that money, it is actually making money. But if it lesser than 12%, it is losing money. So ROIC > WACC is a pre-requisite for a company to make money. In our example, we only had debt. But companies also raise money through equity. So WACC helps find the average rate that company has to pay on the money raised.
Return on assets (ROA):
This one is fairly simple. Return on assets tells you the money the company makes with all its assets. It is the net profit of the company divided by its total assets.
ROA (in %) = Net profits / Total assets * 100%
As we already know that assets = liabilities + equity, you will see that ROA solves the problem of ROE by considering both equity and debt. But it is more limited than ROIC because it uses total assets and net profits instead of "invested capital" and NOPAT. But since Total assets and Net profits are very easy to see in a balance sheet and income statement respectively, ROA is very easy to calculate.
Higher the ROA, the better.
Ensure you compare ROA with only companies in the same sector. Different sectors have widely different ROA ranges. Some sectors are very asset-heavy while others don't need as many assets to operate. Comparing 2 separate sectors may give you a wrong picture.
ROA is best used for banks and financial institutions.
Return on capital employed (ROCE):
Return on capital employed is similar to the other ratios above in that it measures the efficiency of the company's operations. ROCE measures the operating profits (EBIT) the company generates through its "employed capital". Employed capital is very similar to Invested capital in the ROIC formula but slightly simpler to calculate than Invested Capital.
Capital employed is calculated as: Capital Employed = Total assets - Current Liabilities.
Both these values are very easily available in the balance sheet. Check this article if you don't know how to read a balance sheet.
ROCE (in %) = EBIT (Earnings before Interest and Tax)/ (Total assets - Current Liabilities) * 100%
Higher the ROCE, the better.
Like ROIC, ROCE should also be greater than WACC.
Generally, ROCE of 20% or more is considered a good number. Consistent reaching this number for years can indicate an economic moat in the company.
Where to find these ratios?
While it is easy to find these ratios for yourself by finding the required values from the company's balance sheet and income statement, it may be tiring to do this for many companies on end when you are trying to choose between companies.
An easier way is to use websites like screener.in to find these ratios already calculated, ready for use. What's more, you can also use these ratios as filters to separate the grain from the husk. If the company passes the ratio test, you may dive in deeper and invest your time in its analysis.
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