The importance of the financial profitability of a company

In previous articles, we had already referred to the concept of financial profitability, known in Anglo-Saxon literature as Return on Equity (ROE), as a measure of profitability that is closer to shareholders or owners than economic profitability. The proposal for today is to focus on the importance of financial profitability in companies.

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Financial profitability and its relationship with shareholders.

Of the two types of profitability, financial profitability is the indicator that managers most seek to promote in the interests of the owners.

In addition, an insufficient financial return entails a two-way limitation in access to new own funds. In the first place, because this low level of financial profitability is indicative of the funds generated internally by the company; and secondly, because it can restrict external financing.

In this sense, financial profitability should be in line with what the investor can obtain in the market plus a risk premium as a shareholder. However, this admits certain differences, since financial profitability continues to be a return referred to the company and not to the shareholder.

As a result of this, although the shareholders' equity represents the participation of the partners in the company, the calculation of the shareholder's return should be carried out by including magnitudes such as distributable profit, dividends, variation in prices, etc.

And in the denominator, the investment that corresponds to that remuneration, which is not the case of the financial profitability, which, therefore, is the profitability of the company.

Financial profitability is, therefore, a concept of final profitability that, when contemplating the financial structure of the company (in the concept of results and in that of investment), is determined both by the factors included in the economic profitability and by the financial structure as a result of financing decisions.

Why is financial return important?

Financial profitability is mainly used to assess the soundness and efficiency of companies. It is a measure of overall profitability and how well the company's leadership manages its shareholders' money.

When looking for bullish stocks, how important is it that a company can turn a profit? For many, especially investors who prioritize fundamentals, this is very important. Stock returns give investors an idea of how effective a company is at making money.

This metric is especially useful when comparing two stocks in the same industry. For example, if an investor was comparing two similar real estate stocks, some of the metrics may reflect the industry. Digging into a metric like ROE could give you a clearer picture of which stocks have the better balance sheet.

Expressing it as a percentage allows investors to assess this in the absence of distorting figures. For example, a retailer may show huge sales figures and may even use complicated accounting to convert that into millions of dollars of net income in a given year. So in a vacuum, those numbers could make a failing company look good.

Financial profitability allows an investor to divide that income based on the amount of money it took to build a business model. That retailer could perhaps show millions of dollars in net income but could spend hundreds of millions of dollars to generate those sales. That business model looks much less healthy when viewed through a microscope.

It is important to compare the return on capital in comparable companies and industries. Retail, which we mentioned earlier, is traditionally a relatively high-performing industry. A store with a 10% ROE would underperform compared to similarly situated competitors. By contrast, however, a 10% ROE would place a bank in the mid-range for its industry.

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How to estimate the financial profitability in your company?

There are certain practices that, if done correctly, could outline financial profitability. Here we list the main ones.

1. Payment of dividends.

A high return on investment is generally a strong indicator that a company can pay dividends to investors. While this is not necessarily a sign of what the company will choose to do, a well-performing company's ROE can indicate whether it has the capital to make payments to shareholders.

2. Growth.

In general terms, financial profitability indicates how fast you can expect a company to grow (and therefore your return on any investment in that company). Many investors use what is called a retention ratio to estimate a company's future growth. This ratio is the percentage of ROE that a company retains for internal reinvestment after paying dividends to shareholders.

3. The DuPont Analysis.

DuPont Chemical came up with a slightly more complicated way to assess financial profitability. His formula is designed to help investors think about a company's profitability more clearly than the standard ROE formula allows.

The DuPont analysis calculates return on equity by comparing a company's total profit margin to its sales volume and financial leverage. Here are the formulas:

Return on capital

(Net Income / Sales Income) X (Sales revenue / Total assets of the company) X (Total assets of the company / Shareholders' equity).

The overgrowth problem

It is important to be wary of abnormally high returns on capital for the size and character of a company, as well as sudden spikes in individual company returns. Both can be indicators of problems.

Remember that the denominator of the financial profitability formula is equity capital, the comparison of a company's assets to its liabilities. If a company loses assets quickly or goes into heavy debt, its equity capital will fall.

If sales and profits are not affected by this, the sudden drop in the ROE denominator can cause the percentage to rise dramatically. However, that does not necessarily mean that the company is in good health. It could mean anything from an uninspired corporate restructuring to crippling debt problems down the road.

Finally, ROE may return a negative value.

Under normal circumstances, investors do not calculate the financial profitability on equity for companies with negative net income, since in this case, the return is zero.

However, a business can have negative equity capital due to liabilities outweighing assets at a time of positive net income returns. In this case, the ROE will become negative.

A negative ROE is not necessarily a reason to completely ignore a company, but it should be read with great caution. In most cases, negative equity means the company has significant problems with debt, asset retention, or both.

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In general terms, financial profitability allows you to evaluate the solidity and efficiency of your company and helps investors to obtain greater profits.