Is It Profitable?

Why this matters

This module turns the financial statements into answers to the questions investors actually ask. The first is the most basic: is this a good business? Profit in dollars doesn't answer it. A company earning $58 million could be excellent or poor, depending on how much it sells and how much money it took to earn that profit. Margins and returns put profit in context.

Margins: profit per dollar of sales

Costs, Margins, and Profitability introduced three margins. STU Corp's all moved up this year:

Margins answer how much of each sale the company keeps. They don't say how much money the company needed to make those sales. That's what returns measure.

Returns: profit per dollar invested

A return compares profit with the money tied up in the business. Because the balance sheet is a snapshot and profit is earned over a whole year, returns usually divide by the average of the starting and ending balance sheet figures.

Return on equity (ROE) = Net income ÷ Average shareholders' equity

Return on assets (ROA) = Net income ÷ Average total assets

Return on invested capital (ROIC) = After-tax operating income ÷ Average invested capital

Return on equity measures profit against the owners' stake. Return on assets measures it against everything the company owns. Return on invested capital asks how well the business uses all the money supplied by lenders and shareholders together. Here, invested capital is debt plus equity, minus cash, and after-tax operating income is operating income minus tax at the company's effective rate.¹

$ millions	Last year	This year
ROE: net income ÷ average equity	44 ÷ 123 = 35.8%	58 ÷ 165.5 = 35.0%
ROA: net income ÷ average assets	44 ÷ 267.5 = 16.4%	58 ÷ 312 = 18.6%
After-tax operating income	62 × (1 − 21.4%) = 48.7	80 × (1 − 21.6%) = 62.7
Average invested capital	192.5	210.5
ROIC	25.3%	29.8%

Invested capital this year is the average of 201 at the start (100 of debt + 141 of equity − 40 of cash) and 220 at the end (90 + 190 − 60). Every measure of the business improved, yet ROE slipped slightly. The next section explains why.

Why ROE can mislead

Return on equity can be split into three parts, which shows what drives it:

ROE = Net margin × (Revenue ÷ Average assets) × (Average assets ÷ Average equity)

The first part is profitability, the second is how hard the assets work, and the third is how much the company relies on borrowed money and other liabilities instead of equity. For STU Corp this year: 14.5% × 1.28 × 1.89 = 35.0%. Last year: 12.6% × 1.31 × 2.17 = 35.8%. Margins improved, but STU Corp paid down debt and kept more profit as equity, so the third part fell. ROE barely moved while the business got better.

The reverse also happens. A company can raise its ROE by borrowing more, or by buying back so many shares that equity shrinks, without its business improving at all. That's why ROIC, which counts debt and equity together, is often the better guide to the quality of the business itself.

Key takeaways

• Margins measure profit per dollar of sales. Returns measure profit per dollar tied up in the business.
• ROE uses shareholders' equity, ROA uses total assets, and ROIC uses debt plus equity minus cash.
• Debt and buybacks can raise ROE without the business improving.
• STU Corp's margins, ROA, and ROIC all rose this year, while its ROE slipped because it relies less on borrowing.

Check your understanding

A company earned $30 million. Its shareholders' equity was $180 million at the start of the year and $220 million at the end. What was its ROE?

1. 13.6%
2. 15%
3. 16.7%

Two companies in the same industry both report a 25% ROE. Company A has no debt. Company B is heavily indebted. Which result says more about the quality of the business?

1. Company A's, because it earned 25% without borrowed money boosting the number.
2. Company B's, because borrowing that much shows lenders trust the business.
3. They're equal, since ROE already takes the company's debt into account.

What's next

A profitable business can still get into trouble if it can't pay its bills or its debts. The next lesson, Is It Financially Strong?, covers the ratios that measure that.