This is Part 1 of a Series.
Balance Sheet, Income Statement, Cash Flow, ROE, Current Ratio, Debt-to-equity ratio, etc...
Balance Sheet, Income Statement, Cash Flow, ROE, Current Ratio, Debt-to-equity ratio, etc...
Stop! Just close your eyes for a moment...
Amidst the confusion these financial terminologies may cause you, ask these
simple, innocent, basic questions to put yourself in the proper mindset, proper framework: How exactly is the company making money?
How profitable is it? And what exactly is driving its business profitability?
Return on Assets (ROA) sheds some light on measuring fundamental business profitability. It doesn't discriminate on equity alone, but all assets regardless of financial structure. |
The fundamental, economic profitability of a business
model... this, from the very eyes of a prospecting businessman investor is most
essential. The company's bread and butter, so to speak, has to be seen and understood after
all, even before committing capital. It maybe oversimplification for me to say
this, but fundamental business profitability can be assessed by looking at the Return on Assets (ROA) which
mathematically is Net Income divided by Total Assets. I emphasize "business profitability" because ROA is able to filter out the effects of debt financing. Profitability is not discriminated on equity alone; rather, it assesses overall asset profitability, i.e. how much rate of return is derived from total assets, regardless whether financed by debt or equity. In contrast to the Return
on Equity (ROE), it doesn't include the financial leverage component which can
amplify a company's good performance.
Core business profitability is computed as follows:
Operating Income / Operating Assets
Non-core business profitability is computed as follows:
Other Income / Other Free Cash Assets
The rationale behind separating profitability into two is
to determine really where profitability is coming from and this gives us a
better understanding of how the business is allocating its assets to generate
profits. Core business is self explanatory; it traces how much rate of return
is the business able to make from its core business operations, i.e. its
business model. We delve into this because of the fact that the business may
also be investing in other assets or investments that has nothing to do with
its core business operations, and deriving profits from there.
Operating income are income purely derived from the
company's core business. If the company makes and sells computers, then we just
look at income derived from this making-and-selling process, i.e. the business'
core operations. We filter it out from profits made from non-core business activities
such as money made from trading stocks, non-recurring gains from sale of real
estate property, etc. Because if the objective really is to understand and
assess the fundamental, profit-making capacity of the company's business model,
then this filtering, indeed, is really necessary.
Operating assets would primarily involve two components;
these are: working capital and capex assets. I would define Working capital not
simply as current assets less current liabilities. Rather, I would define it as
cash & cash equivalents and trade assets (i.e. inventory, receivables,
prepaid expenses, deferred assets). This is that liquidity in the firm which it
utilizes to cover all related operating expenses to keep it running. Capex
assets are outlays on tangible enterprise infrastructures, or intangible
rights/concessions which enables and facilitates core operations. It may
involve factories, office buildings, tools and equipments, royalty, trade
rights, etc. In summary, operating assets are all those assets involved in
carrying out the company's core business operations. Continue to Part 2: Dissecting that Process which Drives Business Profitability
http://www.stockcalculation.com/2014/01/stockvaluation.html
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