Profitability Ratios Related to Investments Return on investments Ron Measures the overall effective- ness of manage- iment in. generat- ing profits with its available assets, Return on Investments (RON) As already observed, the profitability ratios can also be computed by relating the profits of a firm to its investments. Such ratios are popularly termed as return on investments (ROD. There are three different concepts of investments in vogue in financial literature: assets, capital employed and share- holders’ equity. Based on each of them, there are three broad categories of ROIs. They are (i) return on assets, (ii) return on capital employed and (iii) return on shareholders’ equity. Return on Assets (ROA) Here, the profitability ratio is measured in terms of the relationship between net profits and assets. The ROA may also be called6.22 Financial Management profit-to-asset ratio. There are various possible approaches to define net profits and assets, accord- ing to the purpose and intent of the calculation of the ratio, Depending upon how these two terms are defined, many variations of ROA are possible. ‘The concept of net profit may be (i) net profits after taxes, (ii) net profits after taxes plus interest, and (iii) net profits after taxes plus interest minus tax savings.'” Assets may be defined as @ total assets, (ii) fixed assets, and (iii) tangible assets. Accordingly, the different variants of the RAO are: Net profit after taxes 1, Return on assets (ROA) = PLOT AIST EES 5 100 (6.28) Average total assets The ROA based on this ratio would be an underestimate as the interest paid to the lenders is excluded from the net profits. In point of fact, the real return on the total assets is the net earnings available to owners (EAT) and interest to lenders as assets are financed by owners as well as creditors. A more reliable indicator of the true return on assets, therefore, is the net profits inclusive of interest. It reports the total return accruing to all providers of capital (debt and equity). Net profit after taxes + Interest 2, ROA = = x 100 (6.29) Average total assets Net profit aft 3, toa 4 Net profit after fas Interest eine 630) Average tangible assets Net profit after taxes + Interest Ai ROA page Slee Seem ee nee 00) 6.31) ‘Average fixed assets ‘These measures, however, may not provide correct results for inter-firm comparisons particularly when these firms have markedly varying capital structures ag interest payment on debt qualifies for tax deduction in determining net taxable income. Therefore the effective cash outflows is less than the actual payment of interest by the amount of tax shield on interest payment. As a measure of operating performance, therefore, Equations 6.29 to 6.31 should be substituted by the following. vantage on interest) or After tax inter Average total assets/Tangible assets/Fixed ‘This equation correctly reports the operating efficiency of firms as if they are all equity-financed, ‘The ROA measures the profitability of the total funds/ investments of a firm. It, however, throws no light on the profitability of the different sources of funds which finance the total assets. These aspects are covered by other ROIs. Return on Capital Employed (ROCE) ‘The ROCE is the second type of ROL, It is similar to the ROA except in one respect. Here the profits are related to the total capital employed. The term capital employed refers to long-term funds supplied by the lenders and owners of the firm, It can be computed in two ways. First, it is equal to non-current liabilities Cong-term liabilities) plus owners’ equity, Alternatively, it is equivalent to net working capital plus fixed assets. Second, it is equal to long-term funds minus investments made outside the firm. Thus, the capital employed basis provides a test of profitability related to the sources of long-term funds. A comparison of this ratio with similar firms, with the industry average and over time would provide sufficient insight into how efficiently the long-term funds of owners and lenders are being used. The higher the ratio, the more efficient is the use of capital employed. (6.32)‘The ROCE ¢an be computed in different ways, using different concepts of profits and capital employed. Thus, Ute Be 6.33) Average total capital employed 1, ROCE Net profit after taxes + Interest ~ Tax advantage on interest Average total capital employed x 100 (6.34) 2. ROCI Net profit after taxes + Interest — Tax advantage on interest ee (6.38) “Average total capital employed — Average intangible assets ql 3. ROCE Return on Shareholders’ Equity ‘This profitability ratio carties the relationship of return to the sources of funds'yet another step further. While the ROCE expresses the profitability of a firm in relation to the funds supplied by the lenders and owners taken together, the return on sharehold- ers’ equity measures exclusively the return on the owners’ funds. ‘The shareholders of a firm fall into two broad groups: preference shareholders Return on and equity shareholders. The holders of preference shares enjoy a preference over shareholders equity shareholders in respect of receiving dividends. In other words, from the net eguity profits available to the shareholders, the preference dividend is paid first and what- | measures the ever remains belongs to the ordinary shareholders. The profitability ratios based on fetuen on the shareholders’ equity are termed as return on shareholders’ equity. There are several oWnets (both measures to calculate the retum on shareholders equity: (i) Rate of retutn on Preference and total shareholders’ equity and (b) equity of ordinary shareholders; (it) earings. aly shareold- per share; (iii) dividends per share; (iv) dividend-pay-out ratio; (v) dividend and fone ett earnings yield; and (vi) price-earnings ratio. Return on Total Shareholders’ Equity According, to this ratio, profitability is measured by dividing the net profits after taxes (but before preference dividend) by the average total shareholders’ equity. The term shareholders’ equity includes @) preference share capital; (ii) ordinary sharehold- ers! equity consisting of (a) equity share capital, (b) share premium, and (©) reserves and surplus less accumulated losses. ‘The ordinary shareholders’ equity is also referred to as net worth. Thus, Net profit after taxes Average total shareholders’ equity _ The ratio reveals how profitably the owners’ funds have been utilised by the firm. A comparison of this ratio with that of similar, firms as also with the industry average will throw light on the relative performance and strength of the firm. Return on Ordinary Shareholders’ Equity (Net Worth) While there is no doubt that, jeg the preference shareholders are also owners of a firm, the real ae preference share! are al 18 of , tl I owners are the ordinary ordinary shareholders who bear all the risk, participate in management and are ghareholders? entitled to all the profits remaining after all outside claims including preference equity dividends are met in full. The profitability of a firm from the owners’ point of view measures the should, therefore, in the fitness of things be assessed in terms of the return to the relurm on the total ordinary shareholders. The ratio under reference serves this purpose. equity funds of Itis calculated by dividing the profits after taxes and preference dividend by the ordinary average equity of the ordinary shareholders, shareholders. x 100. (6.36) Return on total shareholders’ equity =Thus, Net profit after taxes ~ Preference dividend Average ordinary shareholders’ equity or net worth This is probably the single most important ratio to judge whether the firm has earned a satis- factory return for its equity-holders or not. Its adequacy can be judged by () comparing it with the past record of the same firm, Gi inter-firm comparison, and (ii) comparisons with the overall industry average. ‘The rate of return on ordinary shareholders’ equity is of crucial significance in ratio analysis vis-a-vis from the point of the owners of the firm. Earnings Per Share (EPS) measures the profit available to the equity shareholders on a per share basis, that is, the amount that they can get on every share held, It is calculated by dividing the profits available to the equity shareholders by the number of the outstanding shares. The profits available to thé ordinary shareholders are represented by net profits after taxes and preference dividend. Thus, x 100 (6.37) Return on equity funds = 5 = Net profit available to equity-holders POA of ordinary shares outstanding Earnings Per Share (EPS) is a widely used ratio. Yet, EPS as a measure of profitability of a firm ‘ from the owner's point of view, should be used cautiously as it does not recognise the effect of increase in equity capital as a result of retention of earnings. In other words, if EPS has increased over the years, it does not necessarily follow that the firm's profitability has improved because the increased profits to the owners may be the effect of an enlarged equity capital as a result of profit retentions, though the number of ordinary shares outstanding still remains constant. Another limitation of EPS is that it does not reveal how much is paid to the owners as dividend, nor how much of the earnings are retained in the business. It only shows how much earnings theoretically belong to the ordinary shareholders (per share basis). As a profitability ratio, the EPS can be used to draw inferences on the basis of () its trends over a period of time, (ii) comparison with the EPS of other firms, and Gii) comparison with the industry average, (6.38) Cash Earnings Per Share is computed using cash flows from business operations as the numera- tor, This value is determined by adding non-cash expenses, such as depreciation and amortisation to net profits available to equity owners. Thus, Net profit available to equity-owners + Depreciation + Amortisation + Non-cash expenses Number of equity shares outstanding ‘The ratio indicates the cash generating ability (per equity share) of the firm. Like EPS, cash EPS’ should be used with caution, It is beset with all the limitations associated with EPS measure. Book Value Per Share represents the equity/claim of the equity shareholder on a pet’share basis. It is computed dividing net worth (equity share capital’ + reserves and surplus — accumulated losses) by the number of equity shares outstanding (at balance sheet date), as shown in Equation 6.40) Net worth Number of equity shares outstanding Cash’EPS = (6.39) Book value per share = (6.40)