Learning to analyze companies and knowing whether the company is profitable or not for our investments is a real challenge for those who are starting to invest from scratch. Therefore, here we explain the main profitability ratios in a company: the Free Cash Flow Yield, ROCE, ROA, and ROE.
We will explore some of the commonly employed ratios favored by expert analysts. In our discussion, we will clarify the standard ratios found on many financial websites while also introducing some frequently utilized metrics by investment professionals, such as Free Cash Flow Yield. Additionally, we will consider other ratios like the Price-to-Earnings Ratio (PER), Earnings Per Share (BPA), and Dividend Yield when evaluating potential investment opportunities in a company.
One of the ways to measure the risk of stocks is through its variability (volatility); but we must also take into account that we are also incurring a risk, probably unknown when buying a company whose margins are falling, that has negative cash flow, or that is not able to be more profitable than its competition. In this article, we will see some ratios that can help us reduce that “risk”.
What are the profitability ratios in a company, and what are they for?
The profitability ratios of a company are economic and financial indicators that help us know if a company is profitable or not: that is, if, with its activity, the company is able to face the costs and remunerations of its employees and if, in addition, it can obtain profits and if they are managed efficiently.
These indicators will help you choose which company to invest in. Among the most important are the Free Cash Flow, ROA, ROE, or ROCE.
FCF (Free Cash Flow Yield) | Return on Cash Flow | Formula
Free Cash Flow, or the return on free cash flow, is the amount of cash that a company has available after paying all its operating and capital expenses and is a measure of the financial health of a company and its ability to generate cash flow.
In this way, free cash flow can be used to pay debt, finance new projects, or pay dividends to shareholders.
- Positive: If a company has more cash, it needs to pay its expenses.
- Negative: If a company has less cash than it needs to pay its expenses, it will have a negative free cash flow, which, to meet all its obligations to its creditors, will make it enter into higher debt ratios.
Companies with a positive free cash flow are generally considered to be in good financial health, while those with a negative free cash flow are considered to be in poor financial health.
In any case, the formula for the Free Cash Flow Yield, or return on cash flow, is calculated by dividing the cash flow by the number of shares and multiplying this result by the share price. It is one of the most commonly used ratios by analysts to assess which companies are good buys.
It is especially relevant because it takes into account the company’s profit and that it is also in cash, without taking into account payments “deferred”.
It is a very similar ratio to the earnings per share, which would be calculated by dividing the EPS by the share price.
- The lower the ratio, the worse it is, and the higher it is, the better.
Some analysts use free cash flow, because it deducts capital expenses, as they consider it a more accurate measure of the return that shareholders will receive compared to income or profit.
ROA (Return on Assets) or ROI (Return on Investments) | Investment or Asset Return | Formula
ROA, or asset return, is a financial ratio that measures the profitability of a company in relation to its total assets and provides an indication of the efficiency with which a company uses its assets to generate profits. Therefore:
- A high ROA indicates that a company is generating lots of profits with relatively few assets,
- A low ROA indicates that the company is not using its assets efficiently.
In general, ROA can be affected by different factors, such as operational efficiency, asset turnover, and leverage.
The ROA formula is calculated by dividing net income by total assets.
We can also calculate the cash generated by the company in relation to its assets, to compare it with other companies in the sector. To do this we divide the Operating Cash Flow (Operating Cash Flow) by the total assets.
ROA can be used to compare the company with the sector or with the historical ROA of the company itself.
We must take into account that assets are financed through various means. ROA gives us a measure of how capable the company is of translating investment into net income. The higher the ROA, the better. However, we must take into account the level of indebtedness of the company.
ROE (Return on Equity) | Return on Equity (Shareholder) | Formula.
ROE is the return on Equity (what the shareholder would receive). Equity is the difference between total assets and total debt. Or what is the same, the initial capital that the shareholders put into the company, adding the profits that the company has retained and subtracting the own shares (self-catering). These shares do not pay dividends, do not have voting rights, and should not be included as shares in circulation.
The ROE formula is calculated by dividing net income by equity.
ROCE (Return On Capital Employed) | Return on Capital Employed | Formula
ROCE is a financial ratio that measures the degree of generation of profits of a company from its capital investments, in fact, it means “return on capital employed”.
Consequently, ROCE is widely used by analysts to compare different companies and identify which are more efficient in generating profits, in addition to helping make investment decisions.
ROCE can be misleading if a company has high levels of debt because debt will increase the denominator in the ROCE calculation and reduce the reported ROCE. For this reason, it is important to examine ROCE along with other financial ratios.
The ROCE formula is calculated by dividing EBIT by capital employed.
EBIT is the profit before interest and taxes.
While profitability ratios are important, you should also familiarise yourself with financial ratios that most investors don’t know about.
Capital employed is widely used, although it is true that there are different contexts in which it can be used:
- Total assets minus short-term debt (current liabilities). Analysts and investors often calculate ROCE based on average capital employed (taking the average of capital employed between the opening and closing of the financial year).
- It can also be defined as the value of all assets employed for the business.
- Fixed assets plus working capital (current assets minus current liabilities).
It is a similar ratio to ROE, which allows you to know the company’s ability to generate money based on the capital it has.
This indicator is widely used by analysts as a measure to see the company’s ability to generate profits.
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Also, fundamental analysis is a vital aspect of the topic of profitability ratios. We’ve compiled this article to help you understand all there is to know about the process.
What is the difference between ROE and ROCE?
If we compare the ROCE with the ROE we can see the impact on the company’s profitability that the leverage effect has, since with the ROCE we include the indebtedness. The ROE considers the benefits generated on the own capital (the reserves are accumulated in the net worth), but the ROCE is the main measure of efficiency when a company uses all the available capital to generate additional benefits.
In short, there are many ways to know the economic situation of a company through its balance sheet and its income statement. However, some of the most important formulas are the ROE, ROCE, ROA, and Free Cash Flow Yield. And now tell us, do you usually calculate it? Are there technical indicators you would like to delve into?
How can these ratios help reduce investment risk?
These ratios provide insights into a company’s financial health and efficiency. Analyzing them can help reduce the risk associated with investing in companies with declining margins, negative cash flow, or poor profitability compared to their peers.
What’s the difference between ROE and ROCE?
ROE focuses on the return generated on shareholders’ equity, while ROCE considers the return on all capital employed in the business, including both equity and debt. ROCE takes into account the leverage effect of debt on profitability.
Which profitability ratios do you prioritize?
The choice of which ratios to prioritize depends on individual investment goals and strategies. It’s advisable to consider a combination of these ratios to make well-informed investment decisions.