The following ratios are designed to measure the
profitability of the firm, and through using different techniques,
the nature of the profitability also. For instance ROA will give a
gross level of profitability, which when combined with the equity
multiplier (the leverage effect) gives the ROE figure, a more
‘net’ measure of profitability and return on capital. Meanwhile
the net profit margin measures how well the firm can convert its
revenue into net profits. The power of these ratios can be seen when
they’re used to compare companies within the same industry or
across industries as they can in effect ignore the differences in
size. [note though differences in size may be entirely relevant, as
it may have implications in terms of cost of capital, ability to
grow assets, long term growth prospects etc]. In any case these
ratios can be used in filter analysis so filter out the most
profitable companies from a large universe of potential companies.
ROA
(Return on Assets) = NPAT divided by Total assets; (variations
can include using average total assets, or average earning
assets etc).
Equity multiplier
=Total assets divided by net assets (i.e. equity); this
measure the firms use of leverage in a way that can be applied
to the gross return metric ROA to produce the ROE figure. (Also
note 1 divided by the equity multiplier (also called leverage
multiplier etc), produces the equity to assets ratio… or
percentage of equity (which is useful in WACC calculations; and
is also used in banking e.g. regulatory capital ratios).
ROE
(Return on Equity) = NPAT divided by Net Assets (alternatively =
ROA times the equity multiplier). This gives the underlying
return on equity, a measure that shows how profitably the firm
is using its equity; it can also be used as a proxy for the cost
of equity capital, and can be used in the dividend discount
model.
ROavgE
(Return on average Equity) = NPAT divided by [(net assets in
year 1 + net assets in year 2) / 2 ] i.e. NPAT over average
equity of the year. This is essentially the same ratio as
above but instead uses average equity, rather than equity take
as at the balance date.
Net
profit margin
=NPAT divided by total revenue. This ratio shows the % of
total revenue that was converted to net profit; it shows how
efficient the firm is at getting revenue to the bottom line.
However it is best to compare across similar companies, as
differing business models will produce different profit margins,
e.g. super market versus jewellery store. So while this ratio is
useful, it should be supported by more underlying figures such
as ROE.
