Return on equity (ROE) can rise while a company's operations deteriorate. Before you trust a higher ROE, find out whether margins, asset use or financing drove the change.
When you compare businesses, their financing and accounting choices can obscure operating differences. Operating margin and other profitability ratios help separate those effects when you match definitions and measurement periods. Start with the income statement prepared under generally accepted accounting principles (GAAP), the accounting framework governing reported results.
For return metrics, annual earnings usually belong over average capital: beginning balance plus ending balance, divided by two. Averages match income earned throughout a period with resources employed throughout that period. Averaging also supports asset turnover comparisons. Use more frequent observations for seasonal businesses, and follow an exam question's specified convention.
Two companies with identical plants but different debt loads report different net income, so you strip out interest and taxes to compare their operations. Earnings before interest and taxes (EBIT) measures profit before financing interest and income taxes.
Common mistakes
- Calling $34 million EBIT “operating income” when it includes a $4 million nonoperating gain over $30 million operating income.
- Subtracting common dividends from EPS. A $2 million common payout leaves the $12 million common-earnings numerator unchanged.
- Using year-end assets for ROA despite beginning and ending balances. Example 1's $24 million ÷ $160 million gives 15%, instead of 16%.
Bottom line
- EBIT retains depreciation and amortization; EBITDA adds them back.
- Basic EPS uses common earnings and weighted-average common shares.
- Gross, operating, pre-tax and net margins divide different earnings subtotals by revenue.
- ROA uses assets, ROE uses equity, and ROIC uses operating invested capital.
Exam shortcut
Read the requested output before calculating. Mark whether the answer must be dollars, dollars per share, a percentage or times. Circle the denominator. Revenue signals a margin; average capital signals a return; market price signals earnings yield. When two balance-sheet dates appear, calculate the average before dividing. Keep full precision until the final answer.
The full lesson (about 4,221 words, 28 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A4
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