Profitability Ratios and Financial Performance Measures: ROCE, EPS and EBITDA

Two companies in the same industry report identical profit this year. One employs ₦5 billion of capital, the other ₦20 billion. Which is the better performer? The answer is obvious as soon as profit is related to the capital used. Profit alone is almost never a measure of performance; it needs a comparison, with the capital employed, with sales, with the same company’s past, with a competitor.

This topic starts the study of performance measurement for a profit-seeking organisation.

It explains what financial performance should aim at (growth and survival, balancing risk and return), then the main profitability measures: gross, operating and net margins, return on capital employed (ROCE) and its link to margin and asset turnover, return on equity, earnings per share (EPS) and EBITDA, with their strengths and weaknesses and how to analyse and comment on results.

It builds on the earlier topic on the behavioural effects of variances. The next topic covers liquidity, solvency and efficiency ratios.

What financial performance should aim at

For a company, suitable measures of performance should agree with the objective of providing benefits to the shareholders over the long term, in the form of dividends from profits and growth in share price. Share price growth comes mainly from growth in the business and in earnings per share.

But growth should not be pursued if it exposes the company to excessive risk, so the objectives of financial performance are consistent with both business growth and survival. A company should balance risk and return.

Why not use share price and dividends as targets?

• The share price is volatile and affected by the stock market, which management does not control.
• Dividends are controlled by the directors and can be manipulated; they need not follow profit or the long-term outlook.
• It is therefore better to measure the conditions that should lead to share price and dividend growth in the future. To assess strategic performance, the measures should consider the longer term: profits over several years and projections for the future, not simply the last year.

The main profitability measures

Margins

• Gross margin = gross profit ÷ revenue. Shows the profit after direct costs; a fall suggests price cutting, higher input costs or a change in sales mix.
• Operating margin = PBIT ÷ revenue. Shows the effect of overheads on top of gross margin. If gross margin is steady but operating margin falls, overheads are the problem.
• Net margin = profit after tax ÷ revenue, after interest and tax.

Return on capital employed (ROCE)

ROCE = profit before interest and tax ÷ capital employed, where capital employed is equity plus long-term debt (or total assets less current liabilities). It relates the profit to the capital invested and so is an indicator of efficiency in using it. It splits into two:

ROCE = operating margin × asset turnover, where asset turnover = revenue ÷ capital employed.

A change in ROCE can therefore be traced to margin (price, cost) or to turnover (use of assets).

Weaknesses: it depends on accounting conventions for profit and for capital employed (depreciated historical costs make old assets look cheap and ROCE high), so it is not a reliable guide to the economic return; and it can discourage investment in projects that would earn more than the cost of capital but less than the current ROCE.

Return on equity and earnings per share

Return on equity (ROE) = profit after tax ÷ equity, the return to owners; it rises with gearing, along with risk.

Earnings per share (EPS) = earnings attributable to ordinary shareholders ÷ number of ordinary shares; EPS growth is commonly used. If the price/earnings ratio stays steady over the long term, growth in EPS should lead to a higher share price. But the P/E may change if investors’ view of risk changes.

Some growth companies, especially technology firms, achieve share price growth without profits, so EPS (or loss per share) is not appropriate for them. EPS can also be raised by buying back shares or by taking on debt, without improving the business.

EBITDA

EBITDA is earnings before interest, tax, depreciation and amortisation. It is useful as a performance measure only if managers have no control over interest and depreciation, which may be true for a profit centre manager but not for those with investment and financing decisions. It is a useful approximation to cash flow from operations before interest and tax.

It ignores the cost of replacing assets and the cost of capital, and so can flatter a capital-intensive business.

Investment centres

For divisions that are investment centres, return on investment (ROI) or residual income is used; their benefits and limits are the subject of a later topic on divisional performance.

Which measure?

None of these alone measures success in earning a return that is consistent with the risks to which the company and its owners are exposed. A set of measures is used together: profitability (margins, ROCE), growth (revenue, EPS, profit over several years), cash flow, and measures of risk (liquidity and gearing, in the next topic).

Results should always be compared: with previous years, with budget, with competitors and with the industry, and then explained.

Layouts for profitability analysis

1. Profit lines: gross profit, PBIT, profit before and after tax; depreciation for EBITDA.
2. Margins as a percentage of revenue, for each year.
3. Capital employed; ROCE; asset turnover; check ROCE = margin × turnover.
4. ROE, EPS, EBITDA and growth percentages.
5. Comment: what changed, why it might have, and the implication.

Percentages to one or two decimal places; money in naira millions; each answer is rounded once, at the end.

Worked examples

1. Profits. Year 1: gross profit 2,800; PBIT 1,300; PBT 1,100; tax 330; PAT 770. Year 2: gross profit 2,760; PBIT 1,200; PBT 940; tax 282; PAT 658.
2. Margins. Gross: 35.0% then 30.0%. Operating: 16.25% then 13.04%.
3. ROCE.
   1,300 ÷ 6,500 = 20.0%
   1,200 ÷ 7,800 = 15.38%.
   Asset turnover: 8,000 ÷ 6,500 = 1.23
   9,200 ÷ 7,800 = 1.18.
   Check: 16.25% × 1.2308 = 20.0%
   13.04% × 1.1795 = 15.38%.
4. ROE.
   770 ÷ 4,000 = 19.25%
   658 ÷ 4,300 = 15.3%.
   EPS: ₦0.770 then ₦0.658.
5. EBITDA.
   1,300 + 400 = 1,700
   1,200 + 420 = 1,620.
   Revenue growth 15.0%; interest cover 6.5 then 4.6.
6. Comment. Revenue grew by 15%, but every profit measure fell. Gross margin dropped five points, so the extra sales were bought with lower prices or higher input costs; overheads rose by only 4%, so the operating margin fell less than the gross margin did. Capital employed rose by 20%, faster than revenue, so asset turnover also fell. ROCE therefore fell from 20% to 15.4% because of both margin and turnover. Higher borrowing cut interest cover. The growth has not added value, and management should examine pricing and the return on the new capital.

1. EPS.
   (800 − 100) × 0.75 ÷ 500 = ₦1.05
   (880 − 150) × 0.75 ÷ 500 = ₦1.095.
2. EBITDA.
   800 + 150 = 950
   880 + 200 = 1,080 (up 13.7%).
3. ROCE.
   800 ÷ 4,000 = 20%
   880 ÷ 5,500 = 16%.
4. Comment. EPS and EBITDA rose (by 4.3% and 13.7%), but ROCE fell, because capital employed grew by 37.5% and profit by only 10%. Growth was financed by capital and debt, the interest cost took part of the gain, and EBITDA overstates the benefit because the higher depreciation shows that the asset base has grown.

Expect variants: a table of several years, ratios to be calculated and explained using background information in the question, a request to suggest improvements, and a requirement to discuss the usefulness and limits of ROCE.

Arguments for using profit as the measure of performance

Profit is a generally accepted measure, used inside and outside the business; it rewards managers who meet targets; external users judge directors’ stewardship by it, and earnings influence share prices.

It is intuitive (a trader’s gain after replacing stock and living costs); it shows the amount that can be distributed while keeping capital intact, so ROCE and earnings per share measure how wealth grows; it is simple and clear to many users; it combines revenues, costs and expenses into one view; it matches the interests of shareholders; it shows how efficiently resources are used; and profit-linked bonuses motivate cost control.

Against: profit is short-term, can be manipulated, ignores quality, customers, innovation and risk, and says little about the future, which is why a balanced scorecard is added.

Common mistakes

• Using profit after interest in ROCE. Use PBIT.
• Capital employed on the wrong basis, and different bases in the two years.
• Calculating without explaining. The marks are for the comment.
• Ignoring the link between margin, turnover and ROCE.
• Treating EBITDA as profit.
• Judging on one year only. Strategic performance needs a longer view.

Quick revision

• Aim: growth and survival; balance risk and return; share price and dividends are poor targets.
• Margins; ROCE = PBIT ÷ capital employed = operating margin × asset turnover; ROE; EPS; EBITDA.
• Compare and explain; no measure alone shows return for risk.

How the marks are earned

• Calculation on the right bases.
• Trend and comparison.
• Explanation and a suggestion.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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