Profitability Ratios Related to Investments
Return on Investments (ROI)
As already observed, the profitability ratios can also be computed by relating the profits of a firm to its investments. Such ratios are popularly termed as return on investments (ROI). There are three different concepts of investments in vogue in financial literature: assets, capital employed and shareholders equity. Based on each of them, there are three broad categories of ROI. They are (i) return on assets, (ii) return on capital employed and (iii) return on shareholders equity.
Return on Assets (ROA)
Here, the profitability ratio is measured in terms of the relationship between net profits and assets. The ROA may also be called profit to asset ratio. There are various possible approaches to define net profits and assets, according to the purpose and intent of the calculation of the ratio. Depending upon how these two terms are defined, many variations of ROA are possible.
The concept of net profit may be (i) net profits after taxes, (ii) net profit after taxes plus interest, and (iii) net profits after taxes plus interest minus savings. As may be defined as (iv) total assets, (v) flow assets, and (vi) tangible assets. Accordingly, the different variants of the RAO are
The ROA based on this ratio would be an underestimate as the interest paid to the lenders is excluded from the net profits. In point of fact, the real return on the total assets is the net earnings available to owners (EAT) and interest to lenders as assets are financed by owners as well as creditors. A more reliable indicator of the true return on assets, therefore, is the net profits inclusive of interest. It reports the total return accruing to all providers of capital (debt and equity).
These measures, however, may not provide correct results for inter-firm comparisons particularly when these firms have markedly varying capital structures as interest payment on debt qualifies for tax deduction in determining net taxable income. Therefore the effective cash outflows is less than the actual payment of interest by the amount of tax shield on interest payment. As a measure of operating performance, therefore, Equations 7.29 to 7.31 should be substituted by the following.
This equation correctly reports the operating efficiency of firms as if they are all equity financed. The ROA measures the profitability of the total funds investments of a firm. It, however, throws no light on the profitability of the different sources of funds which finance the total assets. These aspects are covered by other ROIs.