Economic and Financial Profitability Analysis

Posted on Jan 30, 2025 in Economy

Profitability and Financial Metrics

Profitability is a concept that relates the results achieved in a fiscal year with the elements that, directly or indirectly, have led to their derivation. Its determination is given by the following ratio:

Profitability = Profit / Capital Invested

Or more broadly:

Profitability = Profit for the Year / Capital Invested

Multiplying and dividing by net sales for the period under analysis, we obtain the two essential components in the formation of profitability:

Return = 1 x 2

  • (1) Profit = Profit / Capital Invested
  • (2) Rotation of Capital = Net Sales / Capital Invested

Economic Profitability

Economic viability is given by the following analytical expression:

RE = RAOII / ATN

Where:

  • ATN = Total Net Assets
  • RAOII = Result from Ordinary Activities Before Interest and Taxes

The profitability ratio is very useful in deciding whether or not to undertake a specific form of investment and finance under financial cost because, as stated, it reports on the economic capacity to generate profits, regardless of how the company is financed.

Multiplying and dividing by net sales for the period considered, we obtain the two essential components mentioned above: margin and turnover. Thus we have:

Economic Performance = RAOII / ATN

= (RAOII / Net Sales) x (Net Sales / ATN)

Financial Profitability

In general, the profitability of a company tries to compare the performance obtained during the financial period under review with the equity capital invested:

RF = RAODI / Capital (CP)

RF = RAODI / Shareholders’ Equity (Average)

Financial Leverage

Financial leverage (AF) refers to the impact that fixed financial costs have on earnings per share as RAOII fluctuates. This effect can be measured by the ratio:

AF = [(GPA2 – GPA1) / GPA1] / [(RAOII2 – RAOII1) / RAOII1]

Where:

  • GPA: Earnings Per Share
  • RAOII: Result of Ordinary Activities Before Interest and Taxes
  • If RE > Ki, then AF > 0: The higher the debt, the higher the returns for shareholders.
  • If RE < Ki, then AF < 0: As debt increases, shareholder profitability decreases.

Relationship between Economic Performance and Financial Profitability

Concept of Financial Leverage:

Indebtedness in a company, while potentially damaging the company’s image, can bring positive results:

a) The financial costs of external resources are comparatively lower than the return on equity (RE) produced by the assets in which the debt is invested. The operation of borrowing is beneficial to shareholders against the lenders.

b) The financial costs of external resources are tax deductible, unlike what happens with distributed profits. This reduces the effective cost of debt.

Relationship between Economic Performance and Financial Performance

Concept of Financial Leverage:

Refers to the impact that financial costs have on earnings per share under the score ranges from ordinary activities before interest and taxes.

  • If AF is equal to 1: Indifference as to the use of own or other resources.
  • If AF is greater than 1: Positive AF following a financial cost of external resources lower than profitability. The higher the borrowing, the greater the RF.
  • If AF is less than 1: Negative AF. Unfavorable proportion to the debt capital/equity. Further indebtedness reduces RF.