Comparing performance

A.   Profit and profitability

The profit made by a company in a particular period is also referred to as its earnings - profits after tax - or net income - money produced minus everything spent to produce it. There are different indicators of profitability- level of profit in relation to what is required to produce it. One measure is EBITDA - earnings before-interest, tax; depreciation and amortization (see the course Balance sheet 1 for these last two items). Comparing the EBITDA of different companies is a good way of comparing their fundamental operating performance before other financial and tax considerations are taken into account. It may be used to see if a company is good at generating cash or cashflow.

Note     

A company's profit (uncountable) from a particular period may also be referred to as its profits (plural). Profits is also used to refer to several periods or several companies.

 

B.    Investment ratios.

Another way of comparing companies is by looking at investment ratios - the relationship of one key figure to another.

One important ratio is return on assets (ROA), where you look at a company's profits for the year in relation to the value of its assets to see how well managers are using those resources. This is an indicator of how well the company is using its capacity - the maximum number of products it can produce in a particular period. Particular levels of ROA may indicate that a company is operating at full capacity or it may have spare capacity.

If a company uses relatively few resources compared to similar companies to generate a higher level of profits, you can say, slightly informally, that it is sweating its assets. But it may reach a point where it is not investing enough in new buildings, equipment, etc. There are limits to how far assets can be made to sweat!

And in companies that depend on knowledge workers for their success, physical assets are less important, so ROA is a less useful measure of performance here.

 

C.    Return on equity

Return on equity (ROE) measures how well a company's managers are using shareholders' equity to invest in activities, and resources that generate profit for shareholders. For example, if in a particular year profit before tax is £50,000 and the company has shareholders' equity at that time of £500,000, it has ROE in that year in 10 per cent.

Like all ratios, this can be compared with figures from other companies in the same industry, or for the same company from year to year. One figure by itself doesn't mean very much.

                       

D.   Leverage

To get a better return on equity/companies may borrow in the form of loans and/or bonds. The amount of a company's borrowing and the interest it pays on this in relation to its share capital is its income leverage. This ratio can be expressed as a percentage; for example, a company that makes £80,000 in operating profit in a particular period and pays £20,000 in interest has leverage of 25 per cent. This can also be expressed in terms of interest cover - the number of times it could pay the interest out of its operating profit; in this case four times.

A company with a lot of borrowing in relation to its share capital is highly or heavily leveraged. You can also say that it is heavily indebted. A company that has difficulty in making payments on its debt is over-leveraged. A company that reduces the amount of debt that it has deleverages.

Note

Leverage is also called gearing, especially in BrE. Companies may be said to be highly geared.