Equity profitability score
This score measures the resources generated by the company relative to the funds contributed by shareholders. This is also known as financial profitability.
How to use the score
The following table can be used as a reference for this score:
| Score value range | Interpretation |
|---|---|
| 0 to 5 | Low equity profitability |
| 5 to 7 | Average equity profitability |
| 7 to 10 | High equity profitability |
Financial profitability concept
Financial profitability, also called return on equity (ROE), measures the profitability obtained from the company's own funds (equity). It is a measure of profitability more directly relevant to the shareholder than economic profitability, which considers the company's profitability regardless of how its assets are financed.
Equity profitability calculation
The traditional way of calculating financial profitability is to divide the company's net income by its equity. Gradement uses its own sophisticated algorithm to calculate this value much more accurately.
For the financial profitability calculation, Gradement uses a combination of the following accounting variables:
- Adjusted firm return on equity
- Firm free cash return on equity
- Net income margin
- Free cash flow margin
And for the Equity profitability score calculation, Gradement compares the economic profitability with:
- the contractual rate of interest
- and a natural rate of interest proxy
Economic and financial profitability
Economic profitability from the liabilities point of view
From an asset point of view, economic profitability can be defined, as we have seen, by considering the funds generated by the company's assets, regardless of how they are financed. It is also possible to view this from the perspective of liabilities. From this point of view, profitability can be seen as the remuneration that the company can distribute to all capital owners, i.e., all sources that finance the company's assets.
Difference with financial profitability
To understand the difference between economic profitability and financial profitability, we have to consider this profitability from the point of view of liabilities. While economic profitability measures the potential remuneration to all financing sources of the company's assets, financial profitability only considers the potential remuneration to the company's equity holders (shareholders).
Relationship between economic and financial profitability
Economic and financial profitability are related by financial leverage, so that:
- If there is no financial leverage, there are no external investors, and therefore economic and financial profitability will have the same value.
- The greater the financial leverage, the greater the financial profitability (assuming financing costs are lower than economic profitability). However, this increase in financial profitability comes at the cost of reduced solvency due to higher interest expenses.