Learn Fundamental Analysis: Profitability Ratios & Leverage Ratios

Profitability Ratios

Some of the profitability ratios include:

EBITDA Margin (Operating Profit Margin)

The Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) Margin is a measure that reflects the effectiveness of a company’s management and the efficiency of its operational approach. It provides insight into the company’s operational profitability, expressed as a percentage. Essentially, it assesses how efficiently the company turns its core operational activities into profits. It’s a good idea to compare a company’s EBITDA margin with its competitors to see how well they manage their expenses.

To calculate the EBITDA Margin,

EBITDA Margin = EBITDA / [Total Revenue — Other Income]

We need to calculate EBITDA, 
EBITDA = Operating Revenues - Operating Expense 
Operating Revenues = Total Revenue - Other Income 
Operating Expense = Total Expense - Finance Cost - Depreciation & Amortization

PAT (Profit After Tax) Margin

The Profit After Tax (PAT) margin is calculated at the final profitability level. When calculating the PAT margin, we subtract all expenses from the company’s total revenue to assess its overall profitability.

To calculate the PAT Margin,

PAT Margin = PAT/Total Revenues

It always makes sense to compare ratios with its competitors.

Return on Equity (ROE)

Return on Equity (RoE) is a crucial ratio that helps investors evaluate how much return shareholders get for each unit of money they invest. It measures how well a company generates profits from shareholder investments, essentially showing how efficiently the company makes profits for its shareholders. A higher RoE is better for shareholders, and it’s a key indicator for investors to identify good investment opportunities in a company. When RoE is high, it means the company generates a lot of cash which also indicates a higher level of management performance.

To calculate ROE,

RoE = Net Profit/Shareholders Equity* 100

The thing to remember is higher the debt a company seeks to finance its asset, higher is the ROE. Therefore, with a high debt a high ROE is not great. Therefore, evaluating ROE becomes extremely important. Using the DuPont Model to calculate the ROE can help to get a clear insight [We will talk about this in the later section]. This can be calculated by:

ROE = (Net Profit/Net Sales)(Net Sales/Avg Total Assets)(Avg Total Assets/Shareholders Equity)

Using this formula, we get insight into three different aspects of the business providing an insight into the company’s operating and financial capabilities.

i.e. Net Profit Margin = (Net Profit/Net Sales)100

This is the first part of the formula which provides insight about the company’s ability to generate profit. It is the same as PAT Margin.

i.e. Asset Turnover = Net Sales/Avg Total Assets

This is the second part of the formula which provides insight on how efficiently the company is using its assets to generate revenue. A higher ratio indicates the company is using its assets efficiently and vice versa for a lower ratio value. This ratio is expressed in number of times per year.

i.e. Financial Leverage = Avg Total Assets/Shareholders Equity

This is the final part of the formula which explains “For every unit of shareholders equity, how many units of assets does the company have”. Let's take an example, if the financial leverage is 5 then it means for every Rs.1 of shareholders equity, the company Rs.5 worth of assets. If a company has a high level of financial leverage and carries a significant amount of debt, it’s a sign that investors should be cautious. The ratio is expressed in number of times per year.

Return on Asset (ROA)

Return on Assets (RoA) measures how well a company turns its assets into profits. It shows how efficiently a company uses its resources. In simple terms, a higher RoA is better.

To calculate ROA,

ROA = Net income + interest*(1-tax rate) / Total Average Assets

Leverage Ratios

Proficiently run businesses opt for borrowing when they anticipate opportunities to utilize the borrowed capital in a setting that yields greater profits than the interest expenses required to service the debt. Nevertheless, excessive debt can diminish the portion of profits allocated to shareholders as interest payments for servicing the debt rise. Therefore, there exists a fine distinction between the good and bad debt. Leverage ratios primarily assess the company’s total debt levels and contribute to a deeper understanding of the company’s financial leverage.

Some of the leverage ratios include:

Interest Coverage Ratio

The interest coverage ratio provides insights into the company’s earnings in relation to its interest expenses. It serves as a valuable metric to interpret the company’s ability to meet its interest payments easily. A low-interest coverage ratio indicates a more significant debt load and an increased risk of bankruptcy or default.

To calculate the Interest Coverage Ratio,

Interest Coverage Ratio = Earnings before Interest and Tax/Interest Payment ( also known as Finance Cost)

Earnings before Interest and Tax (EBIT) = EBITDA — Depreciation and Amortization

Interest Coverage Ratio of 1.49x represents that for every Rupee of interest payment due, a company is generating an EBIT of 1.49 times.

Debt to Equity Ratio

It measures the amount of the total debt capital with respect to the total equity capital. A ratio of 1 signifies an equal balance between debt and equity capital. A higher debt-to-equity ratio (greater than 1) signifies increased leverage and necessitates caution. Conversely, a ratio below 1 indicates a larger equity base in comparison to the debt.

To calculate Debt to Equity Ratio,

Debt to Equity Ratio = Total Debt/Total Equity

Total Debt = Short-Term Debt + Long-Term Debt

Debt to Asset Ratio

This ratio provides insights into the company’s approach to financing its assets, revealing the extent to which debt capital contributes to the funding of its total assets. The greater the percentage, the more concerned an investor should be, as it signifies higher leverage and risk.

To calculate Debt to Asset Ratio,

Debt to Asset Ratio = Total Debt/Total Assets

Financial Leverage Ratio

The financial leverage ratio provides insight into the degree to which assets are supported by equity. Keep in mind that a higher value indicates increased leverage for the company.

To calculate the Financial Leverage Ratio,

Financial Leverage Ratio = Average Total Asset/Average Total Equity

In this article, we learned about Profitability Ratios and Leverage Ratios. In the next article, we will learn about Operating Ratios and Valuation Ratios.

Next Chapter: Operating Ratios & Valuation Ratios