Profitability and Coverage Analysis

Financial statement analysis; ratios used to analyze companies’ abilities to generate profit and to meet long-term obligations, as well as the percentage of debts in a company’s capital structure; ratios that measure and explain companies’ profitability and coverage.

1. Introduction to profitability and coverage financial ratios

In another tutorial, we learned the most common financial ratios used by external parties (i.e. financial institutions, creditors, and individual investors) to measure a company's liquidity and ability to effectively utilize its working capital.

In this tutorial we are going to learn other financial statement analysis tools. We will learn the most common financial ratios to measure a company's profitability and coverage.

Profitability ratios covered in this tutorial include: return on sales (ROS), return on assets (ROA), return on equity (ROE), return on investment (ROI), return on capital employed (ROCE), EBIT (earnings before interest and taxes), and EBITDA (earnings before interest, taxes, depreciation and amortization).

Coverage ratios that we are going to discuss are: debt ratio, debt to equity ratio, capitalization ratio, times interest earned, cash debt coverage, and fixed charge coverage ratio.

To illustrate how financial statement analysis is performed, we will continue using the example of Friends Company. In our example, Friends Company is a manufacturer of valves. It is a growing, profitable company, which conducts business in the United States.

To perform a financial statement analysis, we will study Friends Company's consolidated balance sheets and income statements, which are available at the end of this tutorial. Refer to them when you want to find a particular number on the financial statements. The notes accompanying the aforementioned statements have been omitted in our example because notes to financial statements are usually quite extensive. For the convenience purposes we will use the "abbreviated" numbers presented in the financial statements rather than the entire values. For instance, in the income statement we can find that annual sales were $14,000 for 20X9. Because the numbers are presented in thousands, the company had $14 million ($14,000,000) in sales rather than $14 thousand. Using "abbreviated" numbers will simplify our calculations.

2. Financial analysis of profitability

Profitability is an entity’s ability to generate a profit using available resources. Profitability shows the effectiveness of using assets and equity to generate such profit. Thus, logically, profitability represents a relationship between the profit and resources used to generate this profit.

If a company has a profit (i.e. gross profit, operating profit, income before taxes, net income), which is substantial in relationship to its available resources (assets, equity, investments, etc.), then the company is highly effective or is more successful (profitable) in comparison with other companies in the same industry. On the other hand, when the company’s resources used to generate a profit are substantial in relationship to the profit, the company’s activities have low effectiveness or are even non-profitable (e.g., the company has zero profit or losses).

Ratios measuring profitability are useful in financial analysis. Nevertheless, it is important to remember that profitability ratios only tell part of the story: they help to analyze a company’s performance for a particular period, but they may tell little about the company's financial condition and stability. As a result, it is important to use other ratios as well.

The most common profitability ratios are as follows:

  • return on sales (ROS)
  • return on assets (ROA)
  • return on equity (ROE)
  • return on investment (ROI)
  • return on capital employed (ROCE)
  • earnings before interest and taxes (EBIT)
  • earnings before interest, taxes, depreciation and amortization (EBITDA)
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