Profitability Ratios

After reading this section, you will have been exposed to the different types of profitability ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.

The Basic Earning Power ratio (BEP) is Earnings Before Interest and Taxes (EBIT) divided by Total Assets.

LEARNING OBJECTIVE

• Calculate a company's Basic Earning Power ratio

KEY POINTS

• The higher the BEP ratio, the more effective a company is at generating income from its assets.
• Using EBIT instead of operating income means that the ratio considers all income earned by the company, not just income from operating activity. This gives a more complete picture of how the company makes money.
• BEP is useful for comparing firms with different tax situations and different degrees of financial leverage.

TERMS

• Return on Assets

A measure of a company's profitability. Calculated by dividing the net income for an accounting period by the average of the total assets the business held during that same period.

• EBIT

Earnings before interest and taxes. A measure of a business's profitability.

BEP Ratio

Another profitability ratio is the Basic Earning Power ratio (BEP). The purpose of BEP is to determine how effectively a firm uses its assets to generate income.

The BEP ratio is simply EBIT divided by total assets . The higher the BEP ratio, the more effective a company is at generating income from its assets.

$\frac{\text { EBIT }}{\text { Total Assets }}$

Basic Earnings Power Ratio: BEP is calculated as the ratio of Earnings Before Interest and Taxes to Total Assets.

This may seem remarkably similar to the return on assets ratio (ROA), which is operating income divided by total assets. EBIT, or earnings before interest and taxes, is a measure of how much money a company makes, but is not necessarily the same as operating income:

EBIT = Revenue – Operating expenses+ Non-operating income

Operating income = Revenue – Operating expenses

The distinction between EBIT and Operating Income is non-operating income. Since EBIT includes non-operating income (such as dividends paid on the stock a company holds of another), it is a more inclusive way to measure the actual income of a company. However, in most cases, EBIT is relatively close to Operating Income.

The advantage of using EBIT, and thus BEP, is that it allows for more accurate comparisons of companies. BEP disregards different tax situations and degrees of financial leverage while still providing an idea of how good a company is at using its assets to generate income.

BEP, like all profitability ratios, does not provide a complete picture of which company is better or more attractive to investors. Investors should favor a company with a higher BEP over a company with a lower BEP because that means it extracts more value from its assets, but they still need to consider how things like leverage and tax rates affect the company.