Financial Statement Analysis Chapter 9 Profitability Bonsón, E., Cortijo, V., Flores, F. Content on this file is licensed under a Creative Commons Attribution Non-Commercial No Derivatives Works 3.0
Profitability analysis turn to measuring how a company, after performing its basic activity of sales and services rendered, and paying all the production factors concerned, is able to generate a profit to be distributed among shareholders that can be compared to the total of resources invested
Profitability can be measured from a double perspective, relative to the total investment or to the invested resources themselves.
Return on total investment or return on assets (ROA) calculates the relationship between EBIT ( earnings before interests and taxes ) and total assets , as a measure of the investment necessary to obtain this profit.
Return on equity (ROE): determines the relationship between EBT ( earnings before taxes ), and equity , as a measure of the resources the shareholders have invested in the company.
Added value is the wealth generated by the activity of a company during a specific period, and is calculated by the difference between the value of the production of goods and services and the purchase value of external acquisitions
This difference, which measures the company’s contribution to the economy, is distributed as income: to employees via staff costs, to investors and financial entities via dividends , to interests , to self-finance via provisions, depreciation and amortization, and to governments and public entities via taxes
It therefore assumes the demarcation between the company and its environment, measuring the value that it generates and observing how it is later distributed added to which, even when a company makes a loss it can still generate positive value for society.
Added value + Revenue + Other income + Work performed by entity and capitalised - Raw materials and consumables used - Other expense, by nature Added value, generation
Added value Employee benefits expense Finance costs Income tax expense, continuing operations Dividends Self-financing (reserves, depreciation and impairment) Added value, distribution
The ROE calibrates the relationship between EBT ( earnings before taxes ) and equity, as a measure of the resources that shareholders have invested in the company. The following ratio is used to calculate ROE:
It is also possible to calculate the ROE on the basis of the ROA and the average cost of debt. To obtain the latter, not all debt is considered to carry a cost, for example, the company’s commercial creditors do not usually charge interest when payment for supplies and services is delayed. The average cost of debt is calculated thus:
One company taking on the same additional amount of debt at the same cost is more leveraged than another when its ROE enjoys higher growth.
Or rather, it is more leveraged when, with the same share quantity and ROA, it has a greater ROE due to a superior debt level – in these circumstances, the shareholders have invested fewer funds, thanks to the debt, to finance the same share whose profitability, being a variable relative, is obviously greater .