Page 109 - Microsoft Word - 00 P1 IW Prelims.docx

Financial performance measures in the private sector
2.2 Measuring profitability
The primary objective of a profit seeking company is to maximise
profitability. A business needs to make a profit to be able to provide a
return to any investors and to be able to grow the business by
reinvestment.
Profitability measures –
whole organisation
Advantages
Gross and operating  Easy to calculate
profit
 Widely understood
 Ignores largely
uncontrollable figures,
e.g. tax, interest
 Can calculate as a profit
margin
ROCE (return on capital  Easy to calculate
employed)
 Measures how well a
= operating profit ÷ firm is utilising
(capital employed) × 100 resources invested in it
 Often used by external
investors/analysts
EPS (earnings per share)  Easy to calculate
= (PAT – preference  Calculation precisely
dividends) ÷ weighted defined by accounting
average number of standards
ordinary shares
EBITDA, i.e. earnings  Easily calculated and
before interest, tax and understood
depreciation adjustment
 Ignores depreciation (a
write off over several
years) and tax/interest
(externally generated)
Disadvantages
 Poor correlation to
shareholder wealth
 Can be distorted by
accounting policies
 Poor correlation to
shareholder wealth
 Can be distorted by
accounting policies
 Possible dysfunctional
behaviour and/or a
cutting back in
investment if used as a
performance target
 Poor correlation to
shareholder wealth
 Accounting treatment
may distort measure
 Poor correlation to
shareholder wealth
 Ignores changes to
working capital or
amount of non-current
asset replacement
needed
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