98 Part 2 Fundamental Concepts in Financial Management
4-5d Basic Earning Power (BEP) Ratio
The basic earning power (BEP) ratio is calculated by dividing operating income
(EBIT) by total assets:Basic earning power (BEP)! (^) Total assets__EBIT
! $283.8__
$2,000
! 14.2%
Industry average! 18.0%
This ratio shows the raw earning power of the! rm’s assets before the in" uence of
taxes and debt, and it is useful when comparing! rms with different debt and tax
situations. Because of its low turnover ratios and poor pro! t margin on sales,
Allied has a lower BEP ratio than the average food processing company.^13
4-5e Return on Common Equity
The most important, or bottom-line, accounting ratio is the return on common
equity (ROE), found as follows:
Return on common equity (ROE)! __Common equitNet inc ome (^) y
! $117.5__
$940
! 12.5%
Industry average! 15.0%
Stockholders expect to earn a return on their money, and this ratio tells how well
they are doing in an accounting sense. Allied’s 12.5% return is below the 15.0%
industry average, but not as far below as the return on total assets. This somewhat
better ROE results from the company’s greater use of debt, a point discussed ear-
lier in the chapter.
Basic Earning Power
(BEP) Ratio
This ratio indicates the
ability of the firm’s assets
to generate operating
income; it is calculated by
dividing EBIT by total
assets.
Basic Earning Power
(BEP) Ratio
This ratio indicates the
ability of the firm’s assets
to generate operating
income; it is calculated by
dividing EBIT by total
assets.
Return on Common
Equity (ROE)
The ratio of net income to
common equity; measures
the rate of return on
common stockholders’
investment.
Return on Common
Equity (ROE)
The ratio of net income to
common equity; measures
the rate of return on
common stockholders’
investment.
SEL
F^ TEST Identify! ve pro! tability ratios and write their equations.
Why does the use of debt lower the net pro! t margin and the ROA?
Using more debt lowers pro! ts and thus the ROA. Why doesn’t debt have the
same negative e" ect on the ROE? (Debt lowers net income, but it also
lowers the % rm’s equity; and the equity reduction can o& set the lower
net income.)
A company has $20 billion of sales and $1 billion of net income. Its total assets
are $10 billion,! nanced half by debt and half by common equity. What is its
pro! t margin? (5%) What is its ROA? (10%) What is its ROE? (20%) Would this
! rm’s ROA increase if it used less leverage? (yes) Would its ROE increase? (no)
(^13) A related ratio is the return on investors’ capital, de! ned as follows:
Return on investors’ capital (ROIC)! __Net income Debt $ (^) Equity$ Interest
The numerator shows the dollar returns to all investors, the denominator shows the money investors have put
up, and the resulting ratio shows the rate of return on total investor capital. This ratio is especially important in
r egulated industries such as electric utilities, where regulators are concerned about companies using their
monopoly power to earn excessive returns on investors’ capital. In fact, regulators often try to set electricity prices at
a level that will force the return on investors’ capital to equal a company’s cost of capital, as de! ned in Chapter 10.