Table of Contents

1. Introduction

2. Return on Assets (ROA)

3. Components of ROA

4. Total Assets Turnover

5. Return on Common Shareholders' Equity

6. Components of ROCE

7. Industry-Specific Profitability Ratios

8. Summary

1. Introduction

Analysing the profitability of a company is important to investors and creditors.

Investors derive their returns from dividends and appreciation in security prices. Dividends represent a
distribution of profits, and changes in security prices are correlated with profitability levels. Creditors lend
funds in return for interest charges that are typically covered from profits.
As with common-size analysis, absolute income figures do not provide analysts with the insights they need
to properly assess a company's profitability. They rely on ratios to assess the relative profitability of
companies. In this topic, a number of commonly-used profitability ratios will be examined. Interpreting the
levels and changes in profitability ratios also requires understanding contextual factors associated with the
economy, the industry and the company.

These profitability ratios include:

• return on assets

• return on common shareholders' equity

Objectives: Profitability Analysis

Upon completion of this topic, you should be able to

• describe the two key profitability analysis measures on financial statements

• conduct profitability analysis from financial reports

2. Return on Assets (ROA)

Return on Assets (ROA) measures a company's profitability as a percentage of total assets, regardless of how
these assets are financed. This ratio is typically defined as follows:

Numerator of ROA
The numerator of ROA represents income available for distribution to all suppliers of funds (ie, common
shareholders, preferred shareholders and lenders). Since net income (as reported in the income statement) is
calculated after deducting preferred dividends (if any) and interest expense, these amounts are added back to
provide a measure of income available to all suppliers of funds.
Interest expense is typically tax deductible and it must be adjusted for the tax benefits associated with its
deductibility for tax purposes. For example, assume that Company A reported a net income to common
shareholders of US$10,000 and an interest expense of US$3,000. Assume also that Company A has no
preferred shares and its tax rate is 40%. The numerator will be calculated as follows:
US$10,000 + (US$3,000 x (1 - 0.40)) = US$11,800
Denominator of ROA
The denominator of ROA is measured as the average of total assets for the period because the numerator
reflects earnings for the entire period.
View the following video to gain further insights on ROA:

Return On Assets explained

3. Components of ROA
In order to gain an in-depth understanding of what causes ROA to change, analysts examine ratios that drive
ROA. The two main drivers of ROA are the profit margin ratio and total assets turnover. That is
Profit Margin Ratio
The profit margin ratio provides a measure of the ability of a company to generate profit (before interest) per
dollar of sales.
Total Assets Turnover
Total assets turnover provides a measure of a company to generate sales per dollar of assets.
The higher the profit margin, the higher the ROA. Similarly, the higher the asset turnover, the higher the
ROA. Thus, a company can increase its ROA by increasing one or both of these ratios. For some industries
(such as food retailers), the main driver of ROA is asset turnover. For others (such as heavy machinery
manufacturers), the main driver is profit margin.
The profit margin and total assets turnover computations can be illustrated for a fictitious entity, MMM
Company, as follows:

Relevant data

2019 2018 2017

(US$ millions) (US$ millions) (US$ millions)

Total Assets $15,470 $13,535 $13,670

Net Income $2,122 $1,246

Preferred Shares --- ---

Interest Expense $17 $29

Income Tax Rate 35% 35%

Sales Revenues $35,404 $31,168

During 2019, MMM was able to generate a profit margin (before interest) of 6.025 cents per dollar of sales;
however, it was able to turn over its assets 2.44 times. Combined, the profit margin and the asset turnover
resulted in a ROA of 14.71%.
During 2018, MMM was only able to generate a profit margin (before interest) of 4.058 cents per dollar of
sales; however, it was able to turn over its assets 2.29 times, which is below that for 2019. Combined, the
profit margin and the asset turnover resulted in a ROA of 9.30%.
In order to gain an in-depth understanding of what causes profit margin to change, analysts examine various
"expenses/net sales revenues" ratios. These ratios are readily available from the vertical common-size
income statement because it expresses all income statement items as a percentage of net sales revenues. This
statement shows that MMM's lower profit margin during 2018 mostly reflects a special charge that accounted
for 1.55 cents per dollar of sales.

4. Total Assets Turnover

To gain an in-depth understanding of what causes total assets turnover to change, analysts examine ratios that
drive total assets turnover. Analysts typically compute separate turnover ratios for the key classes of assets:
accounts receivable, inventory and fixed assets. That is:

Total assets turnover, as well as its components, provides a measure of a company's efficiency in managing
its assets. Note the above formulas are similar to that of total assets turnover. However, in the case of
inventory, the numerator is cost of goods sold, not net sales revenues. Since the cost of inventory does not
include a profit margin, it cannot be matched with sales revenues. It has to be matched with the cost of sales
or cost of goods sold.
View the following video to obtain insights into asset turnover and its interpretation:

Financial Accounting: Asset Turnover Ratio

The turnover ratios for MMM for the fiscal years 2019 and 2018 are calculated below:

Relevant data
 2019 2018 2017

(US$ millions) (US$ millions) (US$ millions)

Total Assets $15,470 $13,535 $13,670

Net Income $2,122 $1,246

Preferred Shares --- ---

Interest Expense $17 $29

Income Tax Rate 35% 35%

Sales Revenues $35,404 $31,168

Accounts Receivable $2,586 $2,269 $2,424

Inventory $306 $278 $400
Fixed Assets $913 $826 $996
Cost of Revenues $29,055 $25,661

As with total assets turnover, the higher the turnover for each of these components, the higher the ROA. The
above figures clearly show that MMM was able to improve its receivable turnover, its inventory turnover,
and its fixed assets turnover. Accounts receivable turnover improved from 13.28 times per year to 14.58
times per year.
This can be expressed in days by dividing these figures by 365 (representing the number of days in a year)
with these ratios. MMM was able to turnover its receivables during 2019 every 25 days (365 days / 14.58),
and during 2018 every 27.5 days. Inventory turnover also improved from 75.7 times to 99.5 times. In days,
these figures represent 3.67 days for 2019 and 4.82 days for 2018. Fixed assets also improved from 34.21
times during 2018 to 40.72 times during 2019.
The analysis of ROA does not stop here. The analyst should now ask what caused these turnover figures to
improve. The answer to this question requires a thorough review of the company's credit policy, inventory
systems and control, and growth and expansion strategies.
ROA provides analysts with information about the ability of a company to generate profits from the use of its
assets regardless of how these assets are financed. However, shareholders are more interested in a
profitability measure that reflects profits available to them after deducting the cost of financing. That is, they
are interested in calculating return on common shareholders' equity.

5. Return on Common Shareholders' Equity

Recall that shareholders' claims are accounted for in the equity section of the balance sheet. Recall also that
the income statement provides a measure of the income available to shareholders. The core ratio that analysts
use to assess shareholders' return on their investment is referred to as return on common shareholders' equity
(ROCE). ROCE combines the profitability measure and the level of investment by shareholders and
expresses them in a ratio format as follows:

The numerator reflects net income after deducting preferred dividends. Unlike ROA, ROCE does not add
back the cost of borrowing. The denominator reflects the average of the book values of common
shareholders equity.
View the following video to gain insights into ROCE and its interpretation:

Financial Accounting: Return on Equity

Using MMM's financial statements and incorporating information in the footnotes to these statements,
MMM's ROCE for the fiscal years 2019 and 2018 can be calculated as follows:

Relevant data

2019 2018 2017

(US$ millions) (US$ millions) (US$ millions)

Net Income $2,122 $1,246

Preferred Shares --- ---

Common Equity $4,873 $4,694 $5,622

These figures suggest that during 2019, MMM was able to generate a return for common shareholders of
44.36 cents (24.16 cents in 2018) per dollar of common equity. Clearly these percentages are far higher than
those of ROA. In order to get an idea of how good these ratios are, you need to compare these ratios to those
of comparable companies or industry averages.

6. Components of ROCE
In order to gain an in-depth understanding of what causes ROCE to change, analysts examine ratios that
drive ROCE. ROCE can be broken down into its driving factors using the DuPont method. This method
provides a way to decompose ROCE into measures of profitability, efficiency and leverage. Profitability is
measured on the basis of after-interest profit margin ratio. Efficiency is measured using total assets turnover.
Leverage can be measured in a number of ways. In this case, leverage is measured using the ratio of "average
total assets to average common equity". This can be illustrated as follows:

Since after-interest ROA = after-interest profit margin × total assets turnover, ROCE can be restated as
ROCE = after-interest ROA × Leverage

Thus, the difference between ROA and ROCE relates to the effect of leverage (or the percentage of debt
financing relative to equity financing). Leverage is a measure of the capital structure of the company. In
effect, a company can increase its ROCE by increasing leverage. However, an increase in leverage also
reduces profit margin by the amount of the increase in after-tax interest expense. The net effect of these two
factors can lead to a positive or a negative effect on ROCE. If the company is unable to generate sufficient
return to cover its interest expense, ROCE will decrease as a result of leverage.

Using MMM's financial statements and incorporating information in the footnotes to these statements, the
effect of leverage on MMM's ROCE for the fiscal years 2019 and 2018 are calculated below:

Relevant data

2019 2018 2017

(US$ millions) (US$ millions) (US$ millions)

 Common Equity $4,873 $4,694 $5,622
Total Assets $15,470 $13,535 $13,670
ROA 14.71% 9.30%

These figures clearly show that MMM's leverage has contributed significantly to its ROCE. The increase in
ROCE between 2018 and 2019 can partially be explained by the increase in leverage between these two
periods. In effect, MMM's average total debt in 2019 is 2.03 (1.637 in 2018) times its average common
equity. In order to realise how high or low these leverage ratios are, you need to compare them against
comparable companies or industry averages.
To learn more about the impact that leverage and interest charges have on ROCE, view the animation below.

Impact of Leverage and Interest Charges

from GlobalNxt University

02:33

7. Industry-Specific Profitability Ratios

ROA provides a measure of profitability per dollar of assets. ROCE provides a measure of profitability per
dollar of common equity. For some industries, these ratios may not provide the analyst with a good
understanding of the profitability of companies. For example, it would be more informative to assess the
profitability of airline companies on the basis of return per available seat or per mile flown. Similarly, it
would be more informative to assess the profitability of hospitals on the basis of available beds or patient
days. It is therefore important to recognise that the above ratios should be supplemented with industry-
specific profitability ratios. The nature of these ratios can vary from one industry to another and their form
can be defined after careful understanding of profitability drivers.

8. Summary

The following are the main points covered in this topic:

• The two key profitability measures are return on assets (ROA) and return on common shareholders'
equity (ROCE).

• ROA measures a company's profitability as a percentage of total assets, regardless of how these assets
are financed.

• ROCE measures the profit available to common shareholders after deducting the cost of financing.

• ROA can be broken down into a before-interest profit margin measure and a total assets turnover.

• ROCE can be broken down into an after-interest ROA measure and a leverage measure.

• Total assets turnover measures the efficiency of a company in managing its assets and is broken down
into various asset turnover measures.

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