How to: rating assessment, the profitability ratios
A credit rating provides an accurate evaluation of a company’s reliability and requires a meticulous analysis of all the key factors that can affect a company’s economic and financial balance.
Knowing how to assess a company’s creditworthiness and which information each ratio provides, has at least two benefits:
- it allows the company a self-evaluation of its financials and to tackle critical situations in time;
- it allows an objective and independent assessment of the reliability of clients and partners, avoiding losses caused by the counterparty.
After having examined how to measure solvency (here) and liquidity (and here), let’s now see which data and ratios are used by s-peek to evaluate a company’s profitability.
The profitability ratios
Profitability ratios assess a company’s ability to generate profits on the assets invested.
The most common ratios used for estimating the profitability of a company are ROI and ROE ratios.
ROI, which stands for Return on Investment, measures the margin of return on a given investment.
It’s used to assess the efficiency of an investment not only in the analysis of the financial statement, but in any sector or field (for example, in advertising and marketing, the ROI ratio is used to measure the performance of an advertising campaign).
There are several ways to calculate the return on investment. The formula applied by s-peek is: EBIT / Total Assets (since we want to get a percentage value, the outcome must be multiplied by 100).
The EBIT measures a company’s operating profit, ie. what the company earns by the sole selling of its products or services and before taking into account interests and taxes. This is obtained by subtracting operating expenses and the costs of the goods sold from the operating revenue (sales revenue). On the other hand, total assets are nothing else than the amount of the resources with economical value owned by the company (cash, buildings, equipment, stocks, corporate bond, etc.).
There is no reference value for assessing whether the margin of return on the investment is adequate. It all depends from the average value resulting from the sector comparison. However, the higher the margin, the more worthwhile the investment is.
Similarly, the ROE ratio, which stands for Return on Equity, measure the shareholders’ profit margin.
ROE value is, for example, rather important for listed companies to attract new investors.
ROE is calculated by dividing net income by shareholders’equity. This formula measures the percentage of profit made by the company from its internal financing sources only (ie. whitout borrowing from credit institutes).
Again, there are no benchmarks. The result must be compared with the average values resulting from the sector comparison. Though, if the company has incurred losses, the value of the ratio will be negative regardless of the sector average.
Together with ROI and ROE, two further ratios are used by s-peek to evaluate the profitability: the asset turnover ratio and the EBITDA/sales ratio.
The first one is calculated by dividing sales by total assets and indicates how much revenue a company generates per dollar of assets. In other terms, it estimates the efficiency of a company’s use of its assets in generating sales revenue.
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