Profitability Ratio - An Overview

Profitability ratios are a set of measurements used to determine the ability of a business to create earnings. These ratios are considered to be favorable when they improve over a trend line or are comparatively better than the results of competitors.Let’s look into the following ratios under ‘The Profitability Ratio’:

1. EBITDA Margin (Operating Profit Margin)
2. EBITDA Growth (CAGR)
3. PAT Margin, PAT Growth (CAGR)
4. Return on Equity (ROE)
5. Return on Asset (ROA)
6. Return on Capital Employed (ROCE)

The management's effectiveness is shown by the Earnings before Interest, Tax, Depreciation, and Amortization (EBITDA) Margin. It reveals the effectiveness of the business's operational strategy. The EBITDA Margin reveals the company's operating profitability (in percentage terms). To determine how well the management controls expenses, it is usually advisable to compare the EBITDA margin of the company to that of its rivals.

In order to calculate the EBITDA Margin, we first need to calculate the EBITDA itself.

EBITDA = [Operating Revenues – Operating Expense]

Operating Revenues = [Total Revenue – Other Income]

Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]

EBIDTA Margin = EBITDA / [Total Revenue – Other Income]

Continuing the example of Grameenphone Limited, the EBITDA Margin calculation for the FY21 is as follows:

We first calculate EBITDA, which is computed as follows:

EBITDA = Net income + Interest expense + Taxes + Depreciation & Amortization expense.

= 34,129,056 + 2,595,396 + 26,691,690 + 23,016,177

= 8640 crore (appx)

Hence the EBITDA Margin is:

8640 / 14300 crore

= 60.42%

Answer two questions for you at this stage:

1. What does an EBITDA of BDT 8640 Cr and an EBITDA margin of 60.42% indicate?
2. How good or bad an EBITDA margin of 60.42% is?

The first question is a fairly simple. An EBITDA of BDT 8640 Cr means that the company has retained BDT 8640 Cr from its operating revenue of BDT 14300 Cr. This also means out of BDT 14300 Cr the company spent BDT 5660 Crs towards its expenses. In percentage terms, the company spent 39.58% of its revenue towards its expenses and retained 60.42% of the revenue at the operating level, for its operations.

Now for the 2^nd question, hopefully you should not have an answer.

Remember we did discuss this point earlier in this chapter. A financial ratio on its own conveys very little information. To make sense of it, we should either see the trend or compare it with its peers. Going with this, a 60.42% EBITDA margin conveys very little information.

To makes some sense of the EBITDA margin, let us look at Grameenphone’s EBITDA margin trend for the last 4 years, (all numbers in BDT Crs, except EBITDA margin):  

Even though the EBITDA hasn’t exactly shown an increasing trend from 2019-21, the EBIITDA margin remained at an average of 62%.

To sum it up, we still do not know if Grameenphone’s EBITDA is the best. In order to find out if it is the best, one needs to compare these numbers with its competitors. In case of Grameenphone, it would be Robi Axiata Limited. 

PAT Margin:

The Profit After Tax (PAT) margin is determined at the level of profitability, whereas the EBITDA margin is calculated at the operating level. At the operating level, only operating costs are taken into account; other expenditures, like as depreciation and finance charges, are not. Tax charges are in addition to these expenses. All costs are subtracted from the company's total revenues to determine the PAT margin, which measures the business' overall profitability.

PAT Margin = [PAT/Total Revenues]

PAT is explicitly stated in the Annual Report. Grameenphone’s PAT for the FY21 is BDT 3410 Cr on the overall revenue of BDT 14300 Cr. This translates to a PAT margin of:

= 3410 / 14300

= 23.8%

Here is the PAT and PAT margin trend for Grameenphone:       

Year	PAT (in BDT  Crs)	PAT Margin
2019	3450	24.03%
2020	3700	26.64%
2021	3410	23.8%

Return on Equity (RoE):

The Return on Equity (RoE) ratio is crucial because it enables investors to evaluate the return that shareholders receive for each unit of capital invested. RoE gauges an organization's capacity to generate return on the capital invested by its shareholders. In other words, RoE demonstrates the effectiveness of the business in producing profits for its shareholders. Naturally, the higher the RoE, the better it is for the shareholders. In actuality, this is one of the crucial statistics that aids the investor in determining the company's investable qualities. As a point of reference, the average RoE of leading Bangladeshi corporations is 9 percent or greater.

This ratio is evaluated in comparison to other businesses operating in the same sector and is tracked over time.

Also keep in mind that a high RoE indicates that the company is producing a lot of cash, which reduces the need for outside funding. Therefore, a greater ROE denotes better managerial performance.

RoE can be calculated as: [Net Profit / Shareholders Equity* 100]

There is no doubt that RoE is an important ratio to calculate, but like any other financial ratios it also has a few drawbacks. To help you understand its drawbacks, consider this hypothetical example.

Assume Samin runs a Pizza store. To bake pizzas, Samin needs an oven which costs him BDT 10,000/-. Oven is an asset to Samin’s business. He procures the oven from his own funds and seeks no external debt. At this stage you would agree on his balance sheet he has a shareholder equity of BDT 10,000 and an asset equivalent to BDT 10,000.

Now, assume in his first year of operation, Vishal generates a profit of BDT 2500/-. What is his RoE? This is quite simple to compute:

RoE = 2500/10000*100

=25.0%.

Now let us twist the story a bit. Samin has only BDT 8000/- he borrows BDT 2000 from his father to purchase an oven worth BDT 10000/-. How do you think his balance sheet would look?

On the liability side he would have:

Shareholder Equity = BDT.8000

Debt = BDT 2000

This makes Samin’s total liability BDT 10,000. Balancing this on the asset side, he has an asset worth BDT 10,000. Let us see how his RoE looks now:

RoE = 2500 / 8000*100

        = 31.25%

With an additional debt, the RoE shot up quite significantly that if Vishal had only BDT 5000 and borrowed the additional BDT 5000 from his father to buy the oven. His balance sheet would look like this:

On the liability side he would have:

Shareholder Equity = BDT 5000

Debt = BDT 5000

Samin’s total liability is BDT 10,000. Balancing this on the asset side, he has an asset worth BDT 10,000. Let us see how his RoE looks now:

RoE = 2500 / 5000 *100

=50.0%

Clearly, the higher the debt Samin seeks to finance his asset (which is required to generate profits), the higher the Return on Equity. A high RoE is desirable, but not at the expense of excessive debt. The issue is that when a business has a high level of debt, its operation becomes extremely risky as the cost of financing rises dramatically. Therefore, a close examination of the RoE becomes vitally important. Implementing the 'DuPont Model,' also known as 'DuPont Identity,' is one approach to achieving this goal.

The DuPont Model was created in the 1920s by the DuPont Corporation. DuPont Model divides the RoE formula into three parts, each of which represents a different business function. In DuPont's analysis, both the income statement and the balance sheet are utilized to calculate results.

The RoE according to the DuPont model is determined as follows:

If you look at the formula above, you'll see that the denominator and the numerator cancel each other out, giving us the original RoE formula, which is:

RoE = Net Profit / Shareholder Equity *100

But as we broke down the RoE calculation, we learned more about three different facets of the company. Let's examine the three elements that make up the RoE formula according to the DuPont model:

Net Profit Margin: (Net Profits / Net Sales * 100)

The potential of the corporation to make money is expressed in this, the first component of the DuPont Model. Simply put, this is the PAT margin that we discussed earlier in this chapter. Low net profit margins are a sign of rising costs and heightened competition.

Asset turnover is calculated as Net sales / average total assets.

Asset turnover ratio is a measure of the effectiveness with which a corporation generates revenue by using its assets. A higher ratio indicates that the company is utilising its resources more effectively. A lower ratio could be a sign of management or production issues. The outcome is expressed as the quantity of times annually.

Financial Leverage = Average Total Assets / Shareholders Equity

We can answer the question, "How many units of assets does the company have for every unit of shareholders equity," with the use of financial leverage. For instance, if the financial leverage is 4, the corporation may finance assets worth BDT 4 for every BDT 1 in equity. A corporation that is highly leveraged will have more financial leverage as well as higher debt levels, thus an investor should proceed with caution. The outcome is expressed as the quantity of times annually.

As you can see, the DuPont model divides the RoE formula into three separate parts, each of which provides information on the operating and financial capacities of the company.

Let us now proceed to implement the DuPont Model to calculate Grameenphone’s ROE for the FY21. For this we need to calculate the values of the individual components.

Net Profit Margin: From our calculation earlier, we know the Net Profit Margin for Grameenphone is 23.8%.

Asset Turnover = Net Sales / Average Total assets

We know from the FY21 Annual Report, Net sales of Gramneenphone stands at BDT 14300 Cr.

The denominator has Average Total Assets which we know can be sourced from the Balance Sheet. Basically, the practice is to take average of the asset values for the two financial years.

From Grameenphone’s balance sheet, the total asset for FY21 is BDT 16300 Crs.

Do remember this technique of averaging line items, as we will be using this across other ratios as well.

From ARBL’s annual report we know:

Net Sales in FY21 is BDT 14300 Cr.

Total Assets in FY21 is BDT 16300 Cr

Total Assets in FY20 is BDT 14800 Cr

Average Assets = (16300 + 14800) / 2

= BDT 15550 Cr

Asset Turnover = 14300/ 15550

= 0.91

~1

If a company has an asset turnover ratio of 1, this implies that the net sales of the firm are the same as the average total assets for an entire year. In other words, this would mean that the company generates nearly BDT 1 of sales for every BDT the firm has invested in assets.

We will now calculate the last component that is the Financial Leverage.

Financial Leverage = Average Total Assets / Average Shareholders’ Equity

We know the average total assets is BDT 15550. We just need to look into the shareholders equity. For reasons similar to taking the “Average Assets” as opposed to just the current year assets, we will consider “Average Shareholder equity” as opposed to just the current year’s shareholder equity.

Shareholders’ Equity for FY21 = BDT 4980 Cr

Shareholders’ Equity for FY20= BDT 5210 Cr

Average shareholder equity = BDT 5095 Cr

Financial Leverage = 15550 / 5095

= 3.05 times

Financial Leverage of 3.05 is indeed an encouraging number. The figure above indicates that Grameenphone can support BDT 3.05 of assets for every BDT 1 of equity.

We now have all the inputs to calculate RoE for Grameenphone, we will now proceed to do the same:

RoE = Net Profit Margin X Asset Turnover X Financial Leverage

= 23.8% * 0.91* 3.05

~ 66.05%

DuPont model not only answers what the return is but also the quality of the return.

However if you wish do a quick RoE calculation you can do so the following way:

RoE = Net Profits / Avg shareholders Equity

From the annual report we know for the FY21 the PAT is BDT 3400 Cr.

RoE = 3400 / 5095

= 66%

Return on Asset (RoA):

If you are familiar with the DuPont Model, comprehending the next two ratios should be easy. Return on Assets (RoA) measures how successfully an entity can use its assets to generate profits. Investments in unproductive assets are kept to a minimum by a well-managed business. RoA thus represents how effectively management uses its resources. It goes without saying that the greater the RoA, the better.

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

From the Annual Report, we know:

Net income for FY21 = BDT 3400 Cr

And we know from the Dupont Model the Total average assets (for FY20 and FY21) = BDT 15550 Cr

So, what exactly does interest *(1- tax rate) imply? Consider this: the company's loan is also used to finance assets, which are then used to generate profits. So, in a sense, the debtholders (entities that have made loans to the company) are also shareholders. According to this viewpoint, the interest paid out also belongs to a company stakeholder. Also, the company benefits in terms of paying lesser taxes when interest is paid out, this is called a 'tax shield'. For these reasons, we must include interest (while accounting for the tax shelter) when calculating the ROA.

The Interest amount (finance cost) is BDT 250 Cr. Accounting for the tax shield it would be

= 250* (1 – 30%)

= BDT 175 Crs

Hence ROA would be –

RoA = [3400 + 175] / 15550 Cr

         =22.9%