Financial Storytelling and Data Storytelling with Profitability Ratios

Following on from my earlier blog post, discussing Accounting Ratios, let’s take a look at a specific set: Profitability Ratios.Profitability Ratios can be defined as understanding the effectiveness of the company in generating profit. In this blog post, we will concentrate on profitability ratios, working our way around the flow chart presented here:

Screenshot (1)

The formula are presented below, in terms of their meaning:

  • Return on Net Assets (RONA) (Return on Capital employed) – return on the fixed and current assets less current liability. It is also known as the primary ratio.
  • Return on Equity (Return on Shareholders’ Funds) – This also looks at return on the fixed and current assets less current liability, but it looks at it from the Shareholder’s perspective.
  • Gross Profit Margin – percentage of sales revenue remaining after the expense of making the product / solution / delivering the service is taken into account.
  • Net Profit Margin – This is the percentage of sales revenue that’s left, after all of the expenses of running the firm have been fully met.

Let’s have a look at how they are calculated, and what they mean.
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Calculating the Profitability Ratios

1.Return on Net Assets (RONA) (Return on Capital employed)

Net Profit before long-term interest and tax /

Total Assets less creditors falling due within one year

This figure is expressed as a percentage, so it is multiplied by 100%. That said, at root, it is fundamentally calculated as follows, expressed as a percentage:

Profit /

Capital

Profit can include one of the following metrics:

  • Operating Profit
  • Net Profit before Interest and Taxation
  • Net profit after taxation
  • Net Profit after taxation
  • Net Profit after taxation and preference dividend

Capital can be measured by one of the following options:

  • Total Assets
  • Total Assets less intangible assets
  • Total Assets less current liabilities
  • Shareholders Funds
  • Shareholders’ Funds less preference shares
  • Shareholders’ Funds plus long-term loans
  • Shareholders’ funds plus total liabilities

What combination do you choose? Basically, the MVP answer holds here: it depends. The definitions depend on what business question you are trying to answer. The RONA definition was chosen here in order to illustrate how it differs from Return on Equity, which is explained below.

2. Return on Equity (Return on Shareholders’ Funds)

Net Profit before long-term interest and tax /

Share Capital and Reserves

This figure is expressed as a percentage, so it is multiplied by 100%.

3. Gross Profit Margin

Gross Profit /

Sales

This figure is expressed as a percentage, so it is multiplied by 100%.

4. Net Profit Margin

Net Profit before long-term interest and tax /

Sales

This figure is expressed as a percentage, so it is multiplied by 100%.

It’s possible to see that these ratios are made of five different things. I’m a visual person so I’m marking these in colour since I will need to remember them for my exam!

  • Gross Profit
  • Net Profit before long-term interest and tax 
  • Sales
  • Share Capital and Reserves
  • Total Assets less creditors falling due within one year

Interpreting the Profitability Ratios

With the Return on Net Assets figure, we are looking at the effectiveness of the assets that are financed by long-term creditors as well as the shareholders, and we are looking at the profit generated as a result of these combined assets. Higher RONA can mean that the company using its assets efficiently. Also an increasing RONA may indicate an emphasis on executing efficiently, as evidenced in improved profitability and overall performance.

The Return on Equity ratio looks at the same issue, but from the perspective of the shareholder only. The long-term creditors are partialled out. Understandably, shareholders want to see a high return on equity ratio, since this would show that the organisation is being effective in its deployment of investors’ funds. Shareholders can also track progress by calculating the return on equity at the beginning of a period and then check it again at the end of a period to see if there is a change in return.

Net Profit Margin shows the sales revenue after all of the expenses have been removed. It should be as large as it can possibly be, as long as it is sustainable. However, this should not be taking place at the expense of another aspect of the business. Be wary of short-term attitude to profit. This is sometimes evidenced in the net profit margin.

Limitations on the Productivity Financial Ratios

Accounting Ratios give us useful insights in the management of a company, but it is not the whole story. The business context, and the company itself, should also be considered. RONA does not calculate a company’s future ability to create value. Additionally, the values on the balance sheet might not represent the replacement cost, therefore masking the reality of asset utilisation.

In the next post, we will look at Activity Ratios and how they are calculated, along with some advantages and limitations. We are leading up towards visualizing these ratios in Power BI, and it’s important to understand the ‘why’ as well as the ‘how’ of visualizing these ratios.

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