Imagine two runners. Runner A finishes a 5km race in 20 minutes but is completely exhausted and can't move for two days. Runner B finishes the same race in 22 minutes but is barely sweating and ready to go again. Who is the "better" runner? In investing, Runner B is the highly profitable company—generating returns with minimal strain on its resources.
Profitability ratios help us move beyond absolute numbers. A company making $100 Million in profit sounds great, but if they used $10 Billion in capital to do it, they only earned a 1% return—less than a savings account! We use ratios to determine if the company is an **Efficiency Engine** or a **Capital Guzzler**.
Capital Efficiency
Turning Assets into Earnings
1. Return on Equity (ROE)
ROE is the "Mother of all Ratios." It measures how much profit a company generates with the money shareholders have invested. It tells you how fast the "Owner's Wealth" is compounding.
Benchmark: Generally, a consistent ROE above 15-20% is considered excellent. It shows the management is highly capable of deploying your capital.
2. Return on Capital Employed (ROCE)
ROE can be misleading. A company could have a high ROE simply because it has massive debt (low equity). To get the real picture, we use ROCE. It looks at the returns generated on all the capital used—both Debt and Equity.
Why it matters: If a company's ROCE is lower than its cost of borrowing, it is actually destroying value by taking loans. Always compare ROE and ROCE; they should ideally be close to each other.
3. Return on Assets (ROA)
ROA tells you how efficient a company is at using its "Tools" (factories, computers, inventory) to generate profit. It is particularly useful for comparing companies in the same industry (e.g., comparing two airline companies or two steel plants).
A software company will naturally have a much higher ROA than a manufacturing company because it doesn't need expensive factories to generate sales.
4. The DuPont Analysis: The Deep Dive
Sometimes, a company’s ROE looks fantastic, but you want to know why. Is it because they have high margins? Are they selling products very fast? Or are they just taking too much debt? The **DuPont Analysis** breaks ROE into three parts:
(Efficiency)
(Speed)
(Leverage)
Scenario: Imagine a supermarket (DMart). Their *Margin* is low (maybe 5%), but their *Asset Turnover* is incredibly high (they sell their entire stock every few days). This results in a high ROE. On the other hand, a Luxury Car brand has low *Turnover* but very high *Margins*. Both are good businesses, but the DuPont Analysis shows you their "DNA."
5. Pitfalls of Profitability Ratios
As a fundamental investor, never look at a ratio in isolation. Watch out for these traps:
- One-Time Gains: If a company sells a piece of land, their Net Income spikes, making the ROE look amazing for one year. This is not sustainable.
- Share Buybacks: When a company buys back its own shares, the "Equity" (denominator) decreases, which artificially inflates the ROE even if the profit hasn't grown.
- The Debt Trap: As mentioned, high debt makes Equity small, which makes ROE look huge. This is why you must always check the Debt-to-Equity ratio alongside ROE.
Summary of Module 8
- ROE measures wealth creation for shareholders.
- ROCE is the best measure of overall business health, especially for companies with debt.
- Use the DuPont Analysis to understand if a company is winning via Margins, Speed, or Debt.
- Always compare ratios with Industry Peers and the company's own 5-year history.
A company might be highly profitable, but can it pay its bills tomorrow? A profitable company can still go bankrupt if it runs out of cash. In the next module, we will learn how to measure a company's safety net using Liquidity Ratios.