ROS, ROE and ROA ratios - how to analyze the profitability of a company?
- ROE (Return on Equity) - measures the profitability of equity.
- ROA (Return on Assets) - determines a company's ability to make money from its investments.
- Return on Sales (ROS) ratio - measures a company's profit relative to sales.
- All of the indicators do not have a specific optimal level, and their performance should be compared over time and with that of competitors and industry averages.
- Profitability analysis allows assessing the effectiveness of a company's resource utilization and its ability to generate profits.
- The values of the profitability indicators should be interpreted in the context of changes over time and in comparison with the performance of competitors and industry averages.
- High values of profitability indicators do not guarantee the success of a company, and low values do not necessarily mean failure.
- Profitability analysis should be part of a broader financial analysis that also takes into account other aspects, such as liquidity, debt and efficiency of the company's operations.
The primary goal of any entrepreneur is to make his business profitable. In this case, the most important thing is to find the right tool that allows the company to examine its profitability. One of the basic methods to meet this need is profitability analysis, which can be done through ratios - ROS, ROE and ROA.
Enterprise profitability analysis and its objectives
Profitability analysis is one of the main tools for determining whether an ongoing enterprise is profitable. It can be carried out with the help of appropriate indicators. Among the most popular of these are:
- ROS (Return On Sales), which measures a company's sales effectiveness;
- ROE (Return On Equity), which measures how much profit a company has managed to generate from contributed equity;
- ROA (Return On Assets), which measures a company's ability to generate profits.
Each of the above-mentioned indicators allows you to address a different area of your business. By analyzing profitability, the owner is able to manage his entity more effectively, creating a coherent strategy for further development.
A great advantage in the use of ratios during profitability analysis is also simplicity, since only basic financial data is needed for calculations. However, this does not change the fact that such uncomplicated calculations are able to provide simple and, most importantly, clear information about the financial state of the company.
Who is the company's profitability analysis for?
Profitability analysis, contrary to appearances, is not only performed by large, developed companies, by which we mean various types of companies (joint stock, limited partnerships, general partnerships, or limited liability companies), but also by small businesses or sole proprietorships. In all these groups, the survey supports effective management.
ROS - return on sales ratio
The first analyzed indicator used in profitability analysis is ROS, whose acronym develops as Return on Sales, which stands for Return on Sales. In order to obtain the value of this indicator, it is necessary to perform a calculation using such data as net profit earned by the company and total sales revenue.
What does this look like in practice? This can be illustrated with a simple example.
Let's assume that Mr. Jan is a sole proprietor, providing hairdressing services. In 2020, his total revenue from the services provided was PLN 90,000. His business expenses and taxes amounted to PLN 50,000, which ultimately resulted in a profit of PLN 40,000.
Putting this under the ROS formula, we get a value equal to 44.45%. How to interpret this? The result of the analysis of the ROS ratio is the net profit margin - the amount that the company gained per PLN 1 of revenue from services provided. In the above example, 1 PLN generated about 0.44 PLN of profit. It is a good practice to regularly calculate ROS if the value of the indicator increases. This means that the company is operating more and more efficiently. The opposite case, on the other hand, should be a warning sign for the company, as it may indicate that it is incurring too many costs.
In this case, a value of 44.45% was obtained. How to interpret this? The result of the analysis of the ROS ratio is the net profit margin - the amount that the company gained per 1 zloty of revenue from services provided. In the example above, 1 zloty generated about 44 cents in profit. It is good practice to regularly calculate ROS, if the value of the indicator increases, it means that the company is operating more and more efficiently. The opposite case, on the other hand, should be a warning sign for the company, as it may indicate that it is incurring too many costs.
ROE - return on equity ratio
Another indicator that can be used when analyzing a company's finances is ROE (Return on Equity). This represents the profitability from contributed equity. As before, the value of the indicator is obtained by a simple calculation.
The return on equity ratio determines the rate of return that a company can get from a certain investment. This can be illustrated for the umpteenth time by the example used earlier.
Mr. Jan, satisfied with his hairdressing business, decides to open a second salon. The capital he put into opening it amounted to PLN 30,000. In the first year after opening the salon, it made a net profit of PLN 35,000.
The investment made by the entrepreneur resulted in a return on equity score of 116.67%. As in the case of ROS, here too it is desirable to achieve the highest possible value. Analyzing this indicator allows you to see how a company is doing with the use of its equity. ROE is popular among investors (especially shareholders or stockholders) in case the company is registered on the stock exchange.
ROA - return on assets ratio
The last indicator useful when analyzing a company's finances is ROA (Return on Assets), which stands for return on assets. This indicator helps determine the ability of a company's total capital to generate profit.
ROA gives a manager, investor or analyst an idea of how effectively a company is using its assets to generate profits. In this case, we will use another example.
Imagine Peter and Paul, who intend to open hot dog stands. The former spends US$1,500 on his stand, while the latter spends US$1,000. Peter, after a week, has earned $250 from selling hot dogs, while Paul has earned $200.
In this case, it can be seen that even though Peter earned $50 more, Paul's business is more efficient. ROA therefore shows how efficiently a company manages its assets. As with the previous two indicators, it is worth comparing the results with competitors and industry averages. The company should also compare results recorded in earlier reporting periods.
The question of what is the difference between ROE and ROA is also often raised. Both ratios measure how a company uses its resources. Basically, ROE only illustrates a company's return on equity, ignoring liabilities, unlike ROA. The more leverage and debt a company takes on, the higher ROE will be relative to ROA.
Interpretation of ROA ROE and ROS
In order to get a clear picture of the company, it is useful not only to know the company's profitability indicators and be able to calculate them, but also to be able to interpret them. Don't know how to do it? We come to your aid!
Use the following formula to calculate ROA:
(financial result / equity) x 100%
The higher the ROA level comes out, the better the situation of a given company. In the case of a negative value of the indicator, the company does not generate a profit, but a loss. In order to obtain specific conclusions, one should:
- Compare the result obtained with the average value of the indicator in the industry,
- Analyze the company's previous ROA values and compare them to the current one,
- Compare the result with those of the company's main competitors.
Use the following formula to calculate ROE:
(net profit / equity) x 100%
As with ROA - the higher the ROE, the better off your company is. It is important to remember that ROE does not have a single optimal level to determine the level of profitability. Interpretation of the results should be based on changes in this indicator over time. If ROE is increasing, it indicates an increase in the company's level of financial security and its growth potential. An increase in ROE may also indicate a competitive advantage for the company.
Use the following formula to calculate ROS:
(net financial result / sales revenue) x 100%
In this case, too - the higher the ROS, the better the condition of the company. It should be borne in mind that there is no specific level that guarantees optimal profitability, just as in the case of ROA and ROE. In order to understand the results accurately, it is necessary to compare them with the results of previous reporting periods, the performance of competitors and industry averages. Incremental values are desirable, but it is also important to keep the ratio stable at a high level. On the other hand, declines in the ROS ratio suggest that costs and tax burdens are absorbing an increasing share of revenues, which is unfavorable for the company.
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The above indicators show how, in a simple way, an entrepreneur is able to check the performance of his company. Profitability analysis is often one of the main elements of analyzing a company's finances. Profitability is the factor that indicates whether our venture is profitable and whether there is further business sense. Ratio analysis is one of the ways to be more profitable - such a process allows you to make better financial and strategic decisions.
Nevertheless, the ROS, ROE and ROA described here - ROS, ROE and ROA are just the beginning of a serious analysis of a company's performance, which the more advanced, the more tedious, time-consuming and complicated. This should, however, motivate you to further deepen your knowledge of how to analyze your company's finances. Here with a helping hand can come another article our blog, which describes what makes up a break-even analysis and how to do it correctly.
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