Master Class 4: Understanding Return on Equity and Net Profit Margin

Any experienced investor knows that no investment decision can be taken by considering just one or two financial figures. In most cases, the analysis of multiple figures is required to get a clear picture of a company's financial health and performance. The company's financial statements are made public so that any potential investor can make their own analysis based on their evaluation of the data. Hence, to get a full and thorough look at any company's performance and to make an investment decision, one must understand how to evaluate the various financial figures that a company displays.

This article talks about the various important factors and concepts that are required for analyzing a company's performance and its future prospects in terms of investments. The article discusses the concepts of PAT margin or net profit margin, return on Equity, debt-to-equity ratio, and how they influence our choice as a potential investment.

Profit After Tax (PAT) Margin or Net Profit Margin

PAT margin is one of the most important indicators of a company's financial performance. It is the percentage of revenue that remains, after all, operating expenses, interest, and taxes have been deducted from the company's total income.

It is also referred to as 'net profit margin' or net margin. The concept is fairly simple to understand. Let's suppose you buy a box for ₹100 and sell it for ₹125. Hence, the margin or the profit you got is ₹25. This profit relative to the selling price is 20%. This 20% is our PAT margin.

Mathematically, PAT = Profit before Tax (PBT)-Tax

There is often a confusion between the PAT margin and the markup margin. They are often considered to be the same. However, that is not the case.

The PAT margin is always calculated on the selling price and not on the cost price, whereas the markup is calculated on the cost price.

Return on Equity

Return on Equity is one of the most important financial ratios of any company.

The return on equity ratio of a company measures the return rate, which the owners of the company's common stock get in return for their shareholding. Return on Equity informs how efficient a company is in providing returns to the investments which it has received from its shareholders.

Let's consider an example.

Suppose you start a company with a capital of ₹1000. This ₹1000 might entirely be yours, or you have taken them from people in exchange for your company's shares. In any case, this ₹1000 is invested in your company, and it is the total Equity of your company.

Next year, the business gives you a profit of ₹200. Hence, the return on Equity will be 20%.

Mathematically, Return on Equity = Profit x 100/ Total Equity of the company

What is a better parameter?

Both Return on Equity (RoE) and PAT margin are used to measure the company's progress, yet they reflect different aspects of the business. Assume you have ₹1000. You buy some goods worth ₹1000. This ₹1000 is your Equity.

Now you sell these goods for ₹1400. The profit is ₹400. 

The PAT margin would be ₹400/₹1400 = 28.57%

On the other hand, the ROE will be ₹400/₹1000 = 40%

Importantly, it is ROE that would decide if this company proposes a good potential investment opportunity. ROE shows the final return on investment. PAT margin or net profit margin only explains what the company earns against the selling price it offers. A high PAT margin explains that the company spends less on the cost but sells at a high price, but a high ROE shows that the company is earning more.

Have you read our previous Master Class: In-depth Analysis of Dividend, face Value and promoter Holding ?

Is Return on Equity an absolute criterion?

No. Just like all other aspects, a high ROE is good with certain conditions. We will take the example of two companies with a total capital of ₹100. One company has 100% equity, while the other company has 50% equity and 50% debt for its capital. They both have a profit of ₹25.

Here we can see that though the profits are the same, the ROE is different. This is because Company A invests all its money (100% equity) and earns the profit on that. Company B invests only half the money (50% equity) of total capital. It takes 50% as a loan at 10% interest. By the formula, we could see that though the net profit of Company A is more than that of Company B, the returns for B came at a lower equity investment.

So, is Company B, a better company than Company A because its ROE is high? The answer is no. The explanation lies in the concept of debt.

Debt-to-Equity Ratio

In the previous example, Company A performs better than Company B despite its lower ROE. This is because B has a debt. If the profits are pouring, the business will be able to repay the loans and interest. However, if the company is in loss, or is facing a crisis, it will become tough for them to repay the loans. In fact, all their cash liquidity will be spent on loan repayment rather than operations. High debt is one of the major reasons why many companies fail.

If the Equity is high, a company needs to share dividends only if the profits pour in. A company's shareholders are its partners in losses or gains alike.

Debt to Equity Ratio is a financial ratio that indicates the proportion of the usage of shareholders' equity and debt used to finance a company's assets. It compares a company's total liabilities to its shareholders' Equity and can be used to evaluate the amount of leverage a company has employed. The debt-to-Equity ratio is the ratio of the capital taken as debt and as Equity.

Debt to Equity Ratio = Total liabilities / Total shareholders equity

So, look for companies with a low Debt-to-Equity ratio. An ideal situation would be the D/E ratio is zero. This means that, ideally, a company should not have debt at all. For a company to be considered good, its D/E ratio must be very close to 0. This is because in case a company with no debt doesn't earn any profits or incurs losses, its shareholders' will not get any profits. However, if a company having debt incurs a loss, it will still have to pay off the loan interest. This might not yield any returns for its shareholders; instead, it comes off as a loss to them. A repeated loss might even result in bankruptcy or closure of that company.

In our example, Debt/Equity for Company A was 0, while for Company B, it was 1. An investor should look for companies with a low Debt/Equity ratio and a high Return on Equity (ROE). An ROE of more than 20 is desirable for most sectors.

However, this ratio should NOT be considered in the case of banks.

This is where Finology ticker comes in handy. It has a special database that shows only the data relevant to a particular type of company on that company's page. For example, in the case of any banks, the Finology ticker's page for that bank, will not show its debt/equity ratio.

Conclusion

As mentioned earlier, the PAT margin or net profit margin and ROE are two of the most important financial figures of a company that must be taken into account before making an investment decision. However, both reflect different aspects of the business. It is quite often that people tend to get confused between the two. For a better understanding, refer to this YouTube video for examples of real-life companies existing in the current market.

One should always look for a lower Debt-to-equity ratio, but not if the concerned companies are banks. After all, it is the very business of the banks to take money as deposits.

If present on a single platform, all these figures can help in a quicker and more accurate analysis. Finlogy ticker can help you analyze the financial figures of companies working on the stock market, with real-time updates and accurate figures, so that you can start your investment journey with the most accurate decisions.

Check out the next blog series: Asset Turnover, Cash Cycle Ratio and Share Split

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