An Advanced Model for the Study of Profitability - Pt. 3

In this last part of our journey into corporate profitability – and in particular the return on equity – we will try to establish the concepts set out in the two previous contributions with a concrete case.

Let's imagine that we are interested in a certain company Alfa Srl (in the capacity of external analysts, or consultants, or managers, etc.), which has shown decreasing ROE levels over the last three years, and far lower than those of its direct competitors Beta Srl and Gamma Srl, all as highlighted in the following figure:

With the balance sheet data in hand, let's try to understand what may have happened to Alfa Srl, in order to identify any levers of intervention to bring profitability back to levels more in line with the type of business carried out.

The following figure, extracted from our financial analysis software LEAN CFO, shows a summary table with the main balance sheet data and with the 5 levels of depth of ROE decomposition, within the Dupont analysis seen up to now:

As can be easily seen from the multi-colored tabular analysis contained in the screenshot above, the ROE of Alfa Srl went from 29.5% in 2020 to 21.2% in 2021, up to 12.6% in 2022, a value that is perhaps satisfactory in absolute terms, but certainly not in line with the performance of the past and of companies operating in the same sector of activity, which certainly requires the external analyst / consultant / manager to make some necessary reflections, to understand where the critical issues lie.

To this end, and to avoid going too deep here, it may be sufficient to focus on the 3rd level of analysis, the one highlighted in red in the figure and which sees ROE as the product of a profitability indicator (the Profit margin ), an efficiency indicator (the Turnover of invested capital) and an indicator of the degree of financial leverage (the Equity Multiplier).

From the diagram, which is immediately interpretable, we can see how profitability has progressively decreased from 11.0% in 2020 to 7.6% in 2021 until collapsing to the value of 4.8% in 2022.

Similarly, but with less significant variations, efficiency remained essentially unchanged from 2020 to 2021 (from 0.99 to 0.98), before dropping sharply in 2022 to 0.87.

From this first quick analysis, we can conclude that our company Alfa Srl:

• first of all it has a problem of profitability of operational management, which is also confirmed by observing the ROS in the 4th level of depth, which in the years under investigation goes from 16.9% to 12.7% until reaching 9.4%;
• secondly, it also has an efficiency problem , as in 2022 the invested capital is “recovered” through sales revenues only 0.87 times.

These 2 negative effects on ROE are then slightly attenuated by the increase in recourse to debt , as can be seen from the third indicator, the Equity Multiplier, which over the years increases from 2.71 to 2.85 until reaching the value of 3.00.

As seen above, the use of onerous debt, by increasing the leverage effect, also increases the profitability of equity capital; however, this is a very delicate aspect that must be carefully evaluated and monitored with a view to its sustainability in the future, in order not to expose the company to any financial risks , in addition to the inevitable worsening of the credit rating in terms of increased risk of insolvency.

The Dupont analysis above can also be represented graphically in the following way using the Dupont tree , also taken from the LEAN CFO financial analysis software:

The figure clearly and precisely shows the contribution of each element in determining the ROE, performing a significant amount of calculations completely automatically, practically eliminating the possibility of errors and/or inaccuracies in the calculation itself.

Finally, let's now make the comparison with the 2 competing companies, Beta Srl and Gamma Srl, obviously after having recovered the balance sheet data of the latter as well.

Everything is summarized in the usual detailed table:

Even in this case, in our illustrative representation it may be sufficient to stop at the 3rd level of analysis, and from there draw our conclusions on why the two direct competitors Beta Srl and Gamma Srl have a return on equity that is respectively double (23.4%) and triple (36.9%) compared to Alfa Srl.

It can be deduced that:

• the profitability of the operating management of the two competitors is clearly higher than that of the company we are analyzing, with a Profit Margin of 9.5% for Beta Srl and even 22.0% for Gamma Srl, which is further confirmed by the trend of the ROS that can be read in level 4, which is 15.0% for Beta and even 34.1% for Gamma, against the 9.4% of the company under examination;
• in terms of efficiency , the primacy goes to the Beta company, which manages to economically recover the invested capital through sales revenues by 1.56 times, compared to 1.16 for Gamma Srl and 0.87 for Alfa Srl, which even in this respect cannot compete with its direct competitors;
• in terms of leverage , competitors can count on a lower recourse to debt ( Equity Multiplier equal to 1.58 for Beta and 1.44 for Gamma, against the 3.00 of Alfa!), which on the one hand provides less leverage to profitability, but on the other hand suggests that they are companies capable of generating a satisfactory level of cash flow , therefore financially solid and, obviously, with a decidedly better rating .

Finally, we would like to make you reflect - to complete this brief journey into the profitability of the company - on how these graphic and tabular analyses (all taken from the same proprietary software, ed.) represented in the previous figures, help to easily identify at a glance which are the dynamics considered responsible for the variations in profitability over time (or between competitors, if a sector analysis is carried out), so as to provide an initial concrete impulse , an initial general indication to be developed then with possible in-depth studies regarding a particular aspect of company management, to understand the deepest critical issues so as to begin an adequate path to resolve these problems.

Once the balance sheet values ​​have been entered, reclassified as per the IV Directive scheme, the LEAN CFO Software is able to automatically process – and extremely quickly, precisely and reliably – the breakdown of the ROE in the various levels of analysis depth just described, allowing for an in-depth investigation of the drivers of profitability and the management dynamics that influence it.