Profit Generation & Managing Debt

Profit Generation & Managing Debt

In this lesson, you’re expected to learn: 
– how a company uses certain ratios to manage their profit generation.
– how to evaluate a company’s debt.

The purpose of all companies is to generate profits – it’s the ultimate reason why anyone starts a business.

In order to make this profit, companies can’t just charge any price they want. If they charge too much, customers go to the competition so every company is limited in its profitability.

In this lesson, we’ll see how we can use some useful equations in order to measure how well a company generates profits, as well as how effective it is at managing them.

Let’s get started!

1) Return on Capital Employed (ROCE)

This equation is a common ratio that relates the overall profitability of a company to the finance used to generate it. The higher the ROCE, the better a company is doing.

You can calculate the return on capital employed by using the following equation:

ROCE = (Profit before interest and tax / Capital employed) x 100

2) Net Profit Margin 

The most common measure of a company’s profitability is the net profit margin. This calculation measures the percentage difference between net profit and turnover (sales).

– it measures the percentage of a company’s sales revenues  that don’t go towards business costs.
– a low profit margin doesn’t necessarily mean low profits.

Net Profit Margin = Net Profit x 100 / Turnover

3) Net Asset Turnover 

Though a company may have plenty of assets, it still needs to know how effective it is at using those assets to generate sales. This is where the net asset turnover equation can be applied which uses the company’s turnover.

– it is important to know as assets that generate sales cost money. For example, if a company has stock that isn’t being sold, it’s paying for its storage.
– it indicates how well a company manages its assets.

Net Asset Turnover = Turnover (Sales) / Capital Employed

4) Gross Profit Margin 

After a company works out how much it needs to cover the direct costs associated with making and selling a product, it needs to know whether it can cover all the indirect costs that it must pay.

Gross profit margin is used to calculate the percentage of sales that are left over to cover these other expenses.

Gross profit margin = (Gross profit / Turnover) x 100

5) EBITDA / Capital Employed 

EBITDA stands for Earnings Before Interest Tax Depreciation and Amortization.

The following equation relates EBITDA to the equity and debt finance used to generate it:

EBITDA / Capital Employed Ratio
= (EBITDA / Capital Employed) x 100

6) Return on Assets 

Even if a company has many assets, what‘s important is if they are being used effectively to generate income.

– it measures a company’s ability to turn assets into profit rather than just sales.
– helps determine whether a company can use its assets to develop profitability.

Return on Assets = Net Profit / Average total assets

7) Operating Profit Margin 

Operating profit margin measures the percentage difference between operating profit and turnover.

This equation is only concerned with income from operations, excluding a number of costs and revenues that go into measuring net profit.

Operating Profit Margin = Operating Profit / Turnover

8) Return on Total Equity

As a shareholder, you want to know how much value the company is making for you.

This equation is used to calculate the amount of income a company is able to generate with the equity you invest in it.

Return on Total Equity
= Net profit after tax / Average total equity

9) Return on Investment (ROI) 

When a company raises funds, whether by incurring debt or selling equity, it invests those funds in purchasing things necessary to make the company operate.

The ROI is an extremely common measure that determines how well a company is using those investments to generate profits.

ROI = Net profit / Average long-term liabilities + Average equity

[Optional] What is a Profitability Ratio Analysis?
Debt Ratios

Debt is a big deal for companies – so much so that companies value their capital structure based on how effectively they manage debt. Debt is important compared to equity for three main reasons:

– a company can have more debt than assets. Unlike equity, where the maximum equity is the value of all the company’s assets, debt can exceed assets.
– debt incurs interest that needs to be paid off while equity doesn’t.
– as far as the capital structure goes, using debt as a measure usually provides important information about equity as well.

1) Interest Cover

When evaluating a company’s debt structure, you need to know whether a company can pay the interest it owes on the debt it has incurred. To find out, you use interest cover:

Interest Cover
= Earnings before interest and taxes (EBIT) / Interest expense

An interest cover of more than seven times is generally regarded as safe, with an interest cover of more than three times usually regarded as acceptable.

A low interest cover may mean that the company is at risk of defaulting on its debt obligations. But a very high interest earned may mean that the company isn’t fully using its available capital and could possibly generate additional sales by acquiring more debt to expand its production capacity.

2) Fixed Charge Coverage 

Interest is only one form of fixed charge on which a company can default. Leases are another particularly common form.

To determine whether a company is going to default on any of these charges, you use the equation fixed charge coverage.

This equation is given by the following:
Fixed Charge Coverage
=
 (EBIT + Fixed charges before tax) / (Interest + Fixed charges before tax)

This equation is similar to interest cover but adding the same value (fixed charges before tax) to the top and bottom of the equation changes the end value.

Fixed charge coverage is particularly important for companies that have a high portion of fixed charges other than interest.

3) Debt to Equity Ratio 

When measuring a company’s capital structure, you need to calculate the debt to equity ratio, which tells you the ratio that liabilities compose of a company’s funding compared to equity.

Debt to Equity Ratio = Total liabilities / Shareholders’ funds

A high debt to equity ratio can mean two different things. 

– If a company also has a low interest cover, it was probably a bit too reliant on funding operations with debt and will have a hard time paying its interest.
– If the company also has a very high interest cover, it was probably incurring debt to generate funding beyond what it could earn selling debt to generate sales.

As long as the extra ratio of debt increases a company’s interest earned, the difference in earnings increases the value of equity, balancing out the debt to equity ratio in the long run.

[Optional] Debt-Equity Ratio
Jim Rohn