Unlocking the Power of Financial Ratios Part Two

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In part one of this series, we discussed numerous types of solvency and efficiency ratios and what they might show you about a CUSO’s viability. Continuing on from where we left off, we are going to dive into a few more types of ratios to use including profitability ratios and EBITDA calculations.

Profitability Ratios

Profitability ratios provide insight into the ability of a company to create earnings. High numbers generally are better and are most useful for determining short and long-term trends, or when compared to similarly situated businesses.

The Return on Sales Ratio (Profit Margin) measures the profits after taxes on annual sales. The ratio is calculated by taking the net profit after taxes and dividing it by net sales. A ratio of zero percent means the company is breaking even. The nature of the business will have a significant impact on the size of the ratio (low-margin businesses such as grocery stores tend to have very low ratios compared to technology companies).

Figure 9 – Return on Sales Ratio

2021 2020 2019
Net Profit after Taxes  $          200,000.00  $          100,000.00  $          50,000.00
Net Sales  $          800,000.00  $          700,000.00  $          600,000.00
AS A RATIO 0.25 0.14 0.08

In 2019, the company made $50,000 in profit after $600,000 in sales. This results in a ratio of 0.08, meaning the company made 8 cents for every dollar in sales. In 2020, that number rose to 14 cents, and in 2021 it became a full 25 cents. Whether these are good numbers may depend on the industry the company is in.

The Return on Assets Ratio (ROA) is an important indicator of profitability. The ratio is calculated by taking net profit after taxes and dividing it by total assets. Higher ratios are better, but the industry dictates what the expectations should be.

Figure 10 – Return on Assets Ratio

2021 2020 2019
Net Profit after Taxes  $          120,000.00  $          90,000.00  $          60,000.00
Total Assets  $          300,000.00  $          300,000.00  $          300,000.00
AS A RATIO 0.40 0.30 0.20

In 2019, the company was receiving twenty cents for every dollar in assets. The firm’s ROA increases each year, meaning the assets are returning more profit. Some companies will have an asset-intensive business resulting in a lower ROA, so a low ROA is not necessarily indicative of a problem.

For CUSOs, Return on Equity (ROE) can be one of the most important calculations. The ratio is calculated by taking net profit after taxes and dividing it by net worth. The resulting calculation indicates how well the company’s management is realizing an adequate return on the capital invested by its ownership.

Figure 11 – Return on Equity Ratio

2021 2020 2019
Net Profit after Taxes  $          45,000.00  $          40,000.00  $          20,000.00
Net Worth  $          300,000.00  $          240,000.00  $          240,000.00
AS A RATIO 0.15 0.17 0.08
AS A PERCENTAGE 15% 17% 8%

Although there can be many factors that come into play, investors often look at a return above 12% as being good. In 2019, the firm’s ROE could be considered a bit low; in 2020 and 2021 the company’s ROE may be more in line with investor expectations. Note that the lower ROE in 2019 could certainly be caused by other factors that need to be taken into account.

EBITDA calculations

EBITDA stands for “earnings before interest, taxes, depreciation, and amortization” and is commonly used in examining a firm’s profitability. EBITDA has some limitations but has become more popular as it helps demonstrate business performance by showing earnings before the influence of accounting and financial deductions.

There are three EBITDA calculations to consider. The first is Operating Income EBIDTA.  This is calculated by adding Depreciation and Amortization to Operating Income.

Figure 12 – Operating Income EBITDA Calculation

2021 2020 2019
Revenue  $          110,000.00  $          105,000.00  $          95,000.00
Cost of Goods Sold  $          50,000.00  $          45,000.00  $          45,000.00
GROSS PROFIT $          60,000.00 $          60,000.00 $          50,000.00
Depreciation & Amortization $          5,000.00 $          10,000.00 $          15,000.00
Operating Expenses (SG&A) $          20,000.00 $          20,000.00 $          20,000.00
OPERATING INCOME $          35,000.00 $          30,000.00 $          15,000.00
OPERATING EBITDA $          40,000.00 $          40,000.00 $          30,000.00

Operating Income is a measure of profitability after taking into account operating expenses which includes the cost of doing business. Operating income does not include taxes, interest expenses, or other non-operating expenses. Depreciation and amortization fall under the category of operating expenses but represent non-cash expenses. Removing those non-cash expenses can provide a more accurate picture of a company’s true profitability.

The operating Income EBITDA metric is useful if the business does not have a high level of debt or does not regularly make large purchases of fixed assets. In Figure 11, the Operating Income is higher in 2021 than in 2020; however, Operating EBITDA is the same as the depreciation, and amortization was higher in 2020. Operating EBITDA is lower in 2019 than in 2021 due to lower gross profits. As amortization and depreciation expenses were higher in 2019, Operating EBITDA is much higher than Operating Income, indicating that a large portion of the Operating Income was simply due to depreciation and amortization. While depreciation and amortization should not be ignored as expenses, they are the result of accounting entries that are made over time and may need to be stripped out to understand current-year operations and how they impact profitability.

Another EBITDA calculation is Net Income EBIDTA. This is calculated by adding Interest Expense, Depreciation, Taxes, and Amortization to Net Income. The difference between this calculation and Operating Income EBITDA would be the impact of any non-operating expenses which would be included in Net Income.

Figure 13 – Net Income EBITDA Calculation

  2021 2020 2019
Revenue  $       110,000  $       105,000  $       95,000
Cost of Goods Sold  $         50,000  $         45,000  $       45,000
GROSS PROFIT  $         60,000  $         60,000  $       50,000
Depreciation & Amortization  $           3,000  $           3,000  $         3,000
Operating Expenses (SG&A)  $         35,000  $         30,000  $       30,000
OPERATING INCOME  $         22,000  $         27,000  $       17,000
Interest Expense  $           5,000  $           2,000  $         2,000
Non-Operating Expenses  $           5,000  $           4,000  $         1,000
INCOME BEFORE TAXES  $         12,000  $         21,000  $       14,000
Total Taxes  $           7,000  $           7,000  $         5,000
NET INCOME  $           5,000  $         14,000  $         9,000
NET INCOME EBITDA  $         20,000  $         26,000  $       19,000

In this example, the company’s EBITDA calculation is significantly higher than the net income line. Depending on the company’s business, EBITDA may provide a more accurate view of a company’s profitability. For example, a company that uses amortization to expense the cost of software development may have its profitability skewed, especially if the company is a start-up. Excluding liabilities that do not relate to operational performance allows a focus on the cash profits generated by the company.

However, because depreciation is not reflected in EBITDA, this calculation can lead to serious distortions for a company that has significant fixed assets. Therefore, whether EBITDA is useful or not in this example will depend on whether or not excluding depreciation, interest, and taxes makes sense for the type of business the company is engaged in.

The final metric to consider is EBITDA Margin. This is calculated by dividing EBITDA by total revenue.

Figure 14 –EBITDA Margin

  2021 2020 2019
Revenue  $       110,000  $       105,000  $       95,000
Cost of Goods Sold  $         50,000  $         45,000  $       45,000
GROSS PROFIT  $         60,000  $         60,000  $       50,000
Depreciation & Amortization  $           3,000  $           3,000  $         3,000
Operating Expenses (SG&A)  $         35,000  $         30,000  $       30,000
OPERATING INCOME  $         22,000  $         27,000  $       17,000
Interest Expense  $           5,000  $           2,000  $         2,000
Non-Operating Expenses  $           5,000  $           4,000  $         1,000
INCOME BEFORE TAXES  $         12,000  $         21,000  $       14,000
Total Taxes  $           7,000  $           7,000  $         5,000
NET INCOME  $           5,000  $         14,000  $         9,000
OPERATING EBITDA  $         25,000  $         30,000  $       20,000
NET INCOME EBITDA  $         20,000  $         26,000  $       19,000
OPERATING EBITDA MARGIN 23% 29% 21%
NET INCOME EBITDA MARGIN 18% 25% 20%

The EBITDA margin analyzes how much operating cash is generated for each dollar of revenue earned. A high EBITDA percentage means the company has fewer operating expenses and higher earnings, which shows that the company can pay operating costs and still have a decent amount of revenue left over. For example, a small company might earn $110,000 in annual revenue and have an EBITDA margin of 21%, while a larger company might earn $1,100,000 in annual revenue but have an EBITDA margin of 5%. While the smaller company operates more efficiently and maximizes its profitability, the larger company may be focused on volume growth to increase its bottom line.

What about poor ratios?

A company with poor ratios is not necessarily in trouble or a bad investment. Whenever analyzing ratios, understanding context is critical. An important item is to consider whether a transitory or outlier element in the calculation is the reason for the underperformance of a particular ratio.

Not all ratios are applicable or effective in measuring every business. Startups and small businesses often will have poor or wildly fluctuating ratios. (The law of small numbers, where there can be great variability in small numbers, applies). Some ratios may have little applicability to the type of business of the company.

Finally, external events not within the control of the business may significantly impact ratios independent of the management of the business (for example, ratios for a business in the middle of a recession). Of course, all of these caveats apply to excellent ratios as well.

Ratios are evidence, not an answer

Ratios are tools with limitations that need to be understood. Ratios alone cannot provide all the evidence needed for decision-making or to prove a particular CUSO or business is healthy or not. That said, ratios can be exceptional tools for reviewing whether a company is reaching its goals, or how trends affect operations.

Understanding ratios is also important when examiners review a CUSO’s financials. Being able to explain the result of a particular ratio calculation can help demonstrate the CUSO understands the details of its business. Finally, ratios can elevate the financial statements from more than a compliance obligation to valuable information that can be used to analyze the past, present, and future strength of a CUSO.

Authors


  • CFO, CU*Answers. Formerly Chief Financial Officer of a credit union in Virginia, Mr. Frizzle has been involved in the credit union industry since 1988. Mr. Frizzle has served as CU*Answers CFO since joining the 100% credit union-owned cooperative Credit Union Service Organization (CUSO) in 1997. Mr. Frizzle also provides accounting and CFO services to numerous national organizations and CUSOs. These include Xtend, Inc., eDOC Innovations, NACUSO, CU Student Choice, CU*NorthWest, and Chatter Yak. He is an active board member for eDOC Innovations.


  • Internal Auditor, CU*Answers


  • Internal Auditor, CU*Answers

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