Credit Rating calculation: Unveiling the process with s-peek - Profitability
How to assess corporate profitability
We have come to the final article in our journey of exploring credit ratings and how they are calculated within s-peek. In the previous articles, we have talked about the evaluation of solvency and liquidity. In this last part, together with Elisa Graffi, Rating Analyst at modefinance, we will discuss the data and indices used used to evaluate a company's profitability performance.
Understanding Profitability Indices
Profitability indices are used to measure a company's ability to generate profit and cover its costs on the capital, regardless of whether it is invested or at risk.
There are several metrics that can be used to evaluate a company's ability to create profit and value - Elisa Graffi explains. The evaluation usually begins with EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and EBIT (Earnings Before Interest and Taxes), representing the gross and net profit margins that the company earns from selling its products or services.
These, along with the Profit or Loss for the Period, are crucial to profitability analysis.
To proceed with profitability analysis, it is necessary to relate these items to others in the financial statements. Let's explore some of the key indicators used in the evaluation process.
Return on Investments (ROI): definition and calculation
ROI, which stands for Return on Investment, measures the return on investment a company generates.
There are several ways to calculate the return on investment. The formula applied by s-peek is:
ROI = EBIT / Total Assets
Since we want to get a percentage value, the outcome must be multiplied by 100.
Let's break down the formula. As explained by Graffi,
EBIT is the 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. On the other hand, total assets are the sum of capital invested in the company, consisting of fixed assets, inventory, receivables, and liquid assets. Therefore, ROI measyres the return that a company can generate on invested capital, regardless of the financing sources used and its financial structure.
Is there a benchmark value to assess whether the profit margin on investment is satisfactory?
No. Although it's true that a higher margin generally means a more profitable investment, it's important to compare the result with average values of similar companies within the same sector and country. It's also important to consider the company's performance over previous years to understand its trend over time.
How to calculate the Return on Equity (ROE)
Similarly, ROE (Return on Equity) expresses profitability on equity, i.e., the percentage of profit realized by the company using only its resources, excluding any form of external financing. To calculate ROE, the following formula is used:
ROE = Net Income / Shareholders' Funds
Unlike ROI, the result of ROE is not determined solely by operations but also by financial management. ROE should always be interpreted in the context and compared with sector averages (with differences between sectors not to be overlooked).
While it is true that a higher ROE means a higher return on equity, it is equally true that a very high value is not necessarily optimal. For instance, companies with a significant amount of equity may have a lower ROE compared to those that are undercapitalized, even if they have the same net income and assets. This could be an indication of an excessive level of financial leverage or improper use of debt, which could pose a higher risk.
Profitability Metrics: Beyond ROI and ROE
Several indices contribute to profitability analysis. Apart from ROI and ROE, other indices are often more specific. For instance, Return on Capital Employed (ROCE) can be obtained by relating EBIT to Net Invested Capital. ROCE is a useful measure for comparing companies in the same sector with high capital intensity, such as energy companies, automotive companies, and telecommunications companies.
In financial analysis, the Return on Sales (ROS) ratio is commonly used to compare EBIT to Sales Revenue, measuring the percentage of profit generated from sales. It is often used to analyze the performance of industrial and commercial enterprises. However, it is important to compare companies with similar business models, asset volumes, and cost structures. Comparing companies with dissimilar characteristics may lead to inaccurate conclusions.
A similar but more generic index, suitable for automated financial analysis, is the Asset Turnover Ratio. This index, which compares Sales Revenue to Total Assets, allows determining the efficiency of the company in generating revenue from the capital invested in operations.
We have now reached the end of our journey through the main indices used by s-peek to evaluate a company's performance. We hope that this journey has given you a better understanding of how the rating agency modefinance uses its MORE methodology to calculate a company's rating. This approach ensures that the evaluations are consistent and fair, regardless of the company's sector or country of operation.
Apart from financial data, other factors also play a role in the final rating, such as bankruptcy proceedings or black records, the company's longevity and size. If you need any clarifications or additional information, please feel free to contact us via email at email@example.com. Our main goal is to ensure that the evaluation process is transparent, objective and provides a clear assessment of the company reliability.
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