Firm profitability score
This score is a measure of the resources generated by the company in relation to its level of assets.
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 profitability company |
| from 5 to 7 | Average profitability company |
| from 7 to 10 | High profitability company |
Economic profitability concept
The economic profitability, as measured by this score, is a magnitude that compares the funds obtained, during an accounting period, by the company assets (regardless of how they were financed), with the level of investment made by the company to obtain those assets. Suppose the following two companies: (m.u. = monetary units)
| Company | Funds obtained | Investment level to obtain those funds |
|---|---|---|
| A | 100 m.u. | 10.000 m.u. |
| B | 10 m.u. | 100 m.u. |
All things being equal, it might be thought that an investor would prefer company A over company B because A is the one that yields the highest funds, 100 m.u., versus the 10 m.u. obtained by company B. However company B is preferable over company A because to obtain those 10 m.u. B has used comparatively fewer resources than A. Company B had to use 100m.u. to get 10, which implies an economic profitability of 10%, whereas A, to get the 100 m.u. has had to use 10000 m.u., which represents an economic profitability of only 1%.
Of the three main magnitudes that Gradement considers define every company:
- Price, measured with the price/free cash flow score
- Solvency, measured with the dynamic solvency score
- Profitability, measured with the firm profitability score
It is precisely this profitability that is the main measure of comparison between companies. In general, it will be preferable, from the investor point of view, the more profitable company. Although we will always have to condition the comparison with the other two magnitudes of price and solvency. In this way, the objective of the investor must be to mainly look for profitable companies, although conditioning them to also be solvent and not expensive.
Economic profitability calculation
Economic profitability is one of the main parameters, together with solvency and price, which defines the economics of a business. The traditional way of calculating this profitability is simply by dividing the pre-interest profit among the total assets of the company. Gradement uses its own more sophisticated algorithm to calculate this important magnitude much more accurately.
For the economic profitability calculation Gradement uses a combination of the following accounting variables:
- Adjusted firm return on invested capital
- Firm free cash return on invested capital
- Adjusted operating margin
- Operating cash flow margin
And for the Firm 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.