This is Part 2 of a Series. Go to Part 1: Innocent, Unadulterated Profitability Most Businessmen and Entrepreneurs Would Readily Recognize
Our initial focus: EBITDA (Earnings before
Interest, Taxes, Depreciation & Amortization). I would have to be honest
that even I have been a cold skeptic of this metric in the early stages of my
education in investing, but I have come to realize it recently that it is
actually useful for purposes of observing Core Business Profitability. It
filters the distortions of the Interest, Taxes, Depreciation & Amortization
(D&A) portion and primarily focuses on innocent earnings derived from
Working Capital's turnover activity.
Note: We would have to qualify "Earnings" as only those earnings derived from business operations and exclude Other Income which are derived from Non-core Business Investments. Working Capital Turnover, on the other hand, would also have to
be derived using Operating Expenses before D&A to be more meaningful since,
as already explained, Working Capital has nothing to do with covering D&A.
EBITDA / Opex before D&A = Mark-up
Opex before D&A / Working Capital = Working Capital
Turnover
Mark-up x Working Capital Turnover = Working Capital Turnover
Profitability
As earlier discussed, the impact of Working Capital can
only go insofar as to how much it weighs against overall Operating Assets:
Working Capital / Operating Assets = Working Capital
Weight
At this early, innocent stage, we can only observe how
well working capital is contributing to business profitability given its scale
relative to overall operating assets. But as some of you would argue, D&A
are "real" business expenses, and have to be factored in when assessing
profitability. I don't disagree. And that's what we will be doing now.
The diminishing effect of D&A can be expressed as a
ratio of Capex Assets:
Depreciation & Amortization / Capex Assets =
Depreciation Rate
The impact of this Depreciation Rate, similar to Working
Capital Turnover Profitability, can only be so far as to its weight against overall
Operating Assets:
Capex Assets / Operating Assets = Capex Weight
Thus:
(Working Capital Turnover Profitability x Working Capital
Weight) minus (Depreciation Rate x Capex Weight) equals Core Business Profitability
or as expressed mathematically:
EBIT / Operating Assets
Hence:
Core Business Profitability = EBIT / Operating Assets
Core Business Profitability, as we have defined now,
excludes the distortions of Interest and Taxes. Again, Interest is not a cost
of fundamental business operations, but a cost of financial borrowing; what we are after
is profitability regardless of financial structure. Taxes, on the other hand,
is not subjected towards earnings coming from the core business operations alone (i.e. EBIT, as we
have mathematically derived), but all corporate income. It should also thus be excluded. Continue to Part 3: The Cost of Borrowing and Its Impact Against Corporate Profitability
No comments:
Post a Comment