Profit on Capital (LbM), also known as return on investment capital (LbMI), is one of the most important ratios to consider when assessing the profitability of a company. This ratio measures how much money a business or investment can generate on the invested capital. Although important, LBM is rarely reported by companies. Here's how to determine this ratio based on the balance sheet and income statement
Step
Method 1 of 2: Calculating Profit on Capital
Step 1. Understand the equation
See Step 5 below. This calculation is simple as long as you have all the variables, as summarized below.
Step 2. Find the net income for a given year on the income statement
Usually this information is on the bottom line. The income statement shown here is taken from a reputable public company. The report shows that the company's net income for the year ended December 31, 2009 was Rp. 149,940,000. (Please note that all figures in this report are in billions).
Step 3. Subtract any dividends the company may issue
The company does not have to issue dividends, namely income that is distributed to shareholders. Apple, for example, is known as a company that does not issue dividends even though their finances are healthy. However, the total dividend must be listed on the income statement, although you may have to go through the numbers to find it.
Step 4. Based on the balance sheet, determine the amount of capital at the “beginning” of a particular year
Add up debt and total shareholder equity (which includes priority stock, common stock, capital surplus and retained earnings).
- The company's balance sheet in early 2009 appears in the middle column. Based on the figures on the balance sheet as of December 31, 2008, total capital was Rp4,488,911,200 (long-term debt) + Rp1,423,444,000 (total shareholder equity) = Rp5,912,355,200.
- Again, please remember that all figures on this balance are in billions.
- Also note that only long-term debt is included because short-term debt by definition matures no more than one year so the company does not use the money for the entire year of earnings.
Step 5. Subtract dividends from net income, then divide by total capital
The result is a capital gain. In this example, the return on capital is $149,940,000/Rp5,912,355,200 = 0.025, or 2.5%. This means the company made a 2.5% profit on its available capital in 2009.
Method 2 of 2: Ingesting LbM
Step 1. Why is Profit on Capital (LbM) important?
. LbM is a measure of how effective a company is in converting investor capital into profit. Companies that can consistently generate 10% to 15% LBM means that they are good at returning the money invested to their shareholders and bondholders. If you are looking at a company to invest in, this ratio will help a lot.
Find high LbM. The higher the LbM, the better the company will turn money into profit
Step 2. Recognize that an LbM can provide a holistic view
Suppose there is a company with a net income of Rp. 500 million and owes Rp. 100 billion. The company then got a net income of IDR 1 billion so that its net income increased by 100%. If you just look at its revenue growth, you'll miss that the company needs IDR 100 billion in debt to create IDR 1 billion in growth. Their 1% LbM is not very impressive.
- This analogy might help: Imagine basketball players. You might argue that a player who averages 15 points with 20 shots per game plays brilliantly if he can score 30 points. But if you notice that he made 60 shots to get those 30 points, you might think that his game wasn't really that great because he was actually less on target than usual when he got the ball into the basket.
- LbM is also similar. In the basketball game analogy, it is LbM that tells you how efficient a player is at scoring.
Step 3. Recognize that LbM outperforms other ratios in certain situations
Return on capital is a better measure of return on investment than return on equity (LbE) or return on assets (LbA). Equity does not describe all the capital a company uses to fund its operations. Therefore, the return on equity seems high for a company backed by a pile of debt.
- For example, if you put in IDR 1,000,000 to start a business, borrow IDR 10,000,000 and make IDR 500,000 after one year, then your return on equity is IDR 500,000 / IDR 1,000,000, or 50% per year. Seems unreasonable right? Yes, it is. The actual return on invested capital is IDR 500,000/(Rp 1,000,000 + IDR 10,000,000) = 4.55%, a more reasonable figure.
- Asset returns, on the other hand, are unreliable because, as good as they are, the figures for plant and property are rough estimates (since there is generally no ready market for either), while goodwill and intangible assets are attributable to asset estimates. generally an estimate based on agreement.
Step 4. Observe the revenue generated from the business activity itself, not from incidental ones
Look at a company's balance sheet and look for items such as "exchange gains." Do you have to include it in net income? No. This kind of incidental profit is not essential to the company's net results. If included in the LbM ratio, this kind of incidental activity would cloud the numbers on the balance sheet. All you need to include are core business operations if you're thinking about revenue.
