Equity profitability score
This score is a measure of the resources generated by the company in relation to the funds contributed by the shareholders. This factor is also referred as financial profitability.
How to use the score
The following table can serve as a reference for the use of this score:
| Score value range | Interpretation |
|---|---|
| from 0 to 5 | Low equity profitability |
| from 5 to 7 | Average equity profitability |
| from 7 to 10 | High equity profitability |
Financial profitability concept
The financial profitability, also called return on equity (ROE), is a measure of the profitability obtained with the company's own funds (equity). It is a measure of the profitability closest to the shareholder than the economic profitability, which considers the profitability of the company regardless of how its assets are financed.
Equity profitability calculation
The traditional way of calculating this financial profitability is simply by dividing the net income among the equity of the company. Gradement uses its own more sophisticated algorithm to calculate this magnitude 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's point of view
From an assets point of view, economic profitability can be defined, as we have already seen, considering the funds generated by the company's assets, regardless of how they are financed. It is also possible to see this magnitude from the point of view of liabilities. From this point of view, the profitability can be seen as the remuneration that the company can distribute to all the owners of the capital, that is to say, all sources that finance the company assets.
Difference with financial profitability
To understand the difference between economic profitability and the financial profitability, we have to consider this profitability from the point of view of liabilities. While the economic profitability measured the potential remuneration to all the finanicing sources of the company's assets, the financial profitability only considers in its calculation the potencial remuneration to the holders of the equity of the company (shareholders).
Relationship between economic and financial profitability
The economic and financial profitability are both related by the financial leverage, so that:
- If there is no financial leverage there are no external investors to the company and therefore the economic and financial profitability will have the same value.
- The greater the financial leverage, the greater the financial profitability (assuming here that the financing costs are lower than the economic profitability). But this increase in financial profitability is made at the cost of a reduction in solvency because of the now higher interest expenses.