Profitability: ROE, ROA, margins and value added

Three levels of profitability

The IBR-IRE study organises profitability around three questions: what sales yield (margins), what all the means employed yield (return on assets), what the shareholders' money yields (return on equity). The leverage effect links the last two.

Return on equity

This is ratio no. 9 of the National Bank, net return on equity after tax:

ROE = profit (loss) for the year (9904) ÷ equity (10/15) × 100

It is computed in every format, under two conditions set by the NBB: a twelve-month financial year and positive equity (10/15 > 0). It is what every euro left by the shareholders in the company yields.

The trap: when equity is very low, a small profit gives a spectacular ROE. Always read ROE together with solvency.

The NBB publishes next to it ratio no. 10, cash flow ÷ equity, which neutralises depreciation and provisions; the gap between the two says the weight of non-cash charges.

Return on assets

Ratios no. 11 and 12 measure what all the means employed yield, whatever the way they are financed. They are computed before taxes and before debt charges, so as not to depend on the financing mode or on taxation:

Net return on total assets before taxes and debt charges (no. 12) = (9904 + 650 + 653 − 9126 + 9134) ÷ 20/58 × 100

The numerator starts from the result for the year and adds back debt charges (650), discount on receivables (653) and income taxes (9134), less interest subsidies (9126). The gross version (no. 11) also adds depreciation, write-down and provision charges and removes reversals, as for cash flow. In the abridged and micro formats, financial charges are taken as a whole (65) and taxes through 67/77.

The leverage effect

The IBR-IRE devotes a section to financial leverage as a multiplier of return on assets. The idea: if assets yield more than debt costs, every borrowed euro increases the return on equity; if assets yield less than the cost of debt, leverage works in reverse and the loss concentrates on the shareholders. The study details the condition for favourable financial leverage and the case of a negative result.

In practice: a high ROE obtained with weak solvency is a fragile ROE. A rise in interest rates or a drop in activity tips it over.

Margins on sales

Ratios no. 1 and 2 are only computed when turnover is disclosed: mandatory in the full format, "70 > 0" in the abridged and micro formats.

NBB ratio	Numerator	Denominator (full format)
Gross margin on sales (no. 1)	9901 − 76A + 66A + 630 + 631/4 + 635/8	70 + 74 − 740
Net margin on sales (no. 2)	9901 − 76A + 66A + 9125	70 + 74 − 740

Two NBB choices deserve to be understood. The margins start from the operating result (9901), not from the final result: financial charges and taxes do not enter. And they are corrected for non-recurring items (76A removed, 66A added back), to measure the ordinary business.

Margins vary enormously from one sector to another: a few percent in distribution, much more in software or consulting. Only the sector comparison in quartiles gives them meaning.

Value added

The IBR-IRE places value added at the top of the diagnosis: a fundamental measure of the long-term capacity of the company. The NBB makes it its ratios no. 3 to 8.

Gross value added (full format) = 70 + 71 + 72 + 74 − 740 − 60 − 61

For the abridged and micro formats, the NBB estimates it by 9900 − 76A (gross operating margin excluding non-recurring income).

Two ratios follow, useful even without turnover:

• Value added per person employed (no. 4) = gross value added ÷ average headcount in FTE (9087, or 1003 in the micro format): apparent productivity, in euros per full-time equivalent.
• Share of staff costs in value added (no. 6) = (62 + 635) ÷ gross value added × 100: when it lastingly exceeds 100%, the company does not create enough value to pay its staff.

Reading the trend

Profitability is read over at least two years, which the filing always contains:

• rising with growing equity: the company is getting stronger;
• falling but still positive: to be watched, especially if cash follows the same slope;
• an isolated loss after several profitable years: look at whether it comes from operations (9901) or from a non-recurring item (66A, 66B).