Corporate Finance, 6th Edition

Chapter 13RETURN ON CAPITAL EMPLOYED AND RETURN ON EQUITY

The leverage effect is much ado about nothing

So far we have analysed:

• how a company can create wealth (margin analysis);
• what kind of investment is required to create wealth: capital expenditure and increases in working capital;
• how those investments are financed through debt or equity.

We now have everything we need to carry out an assessment of the company's efficiency, i.e. its profitability.

A company that delivers returns that are at least equal to those required by its shareholders and lenders will not experience financing problems in the long term, since it will be able to repay its debts and create value for its shareholders.

Hence the importance of this chapter, in which we attempt to measure the book profitability of companies.

Section 13.1 ANALYSIS OF CORPORATE PROFITABILITY

We can measure profitability only by studying returns in relation to the invested capital. If no capital is invested, there is no profitability to speak of.

Book profitability is the ratio of the wealth created (i.e. earnings) to the capital invested. Profitability should not be confused with margins. Margins represent the ratio of earnings to business volumes (i.e. sales or production), while profitability is the ratio of profits to the capital invested to generate the profits.

Above all, analysts should focus on the profitability of capital employed by studying the ratio of operating profit to capital employed, which is called ...