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What is Meant by Earning Power?
Definition of Earning Power
A company’s ability to generate profit from its operation is known as the company’s earning power. In other words, earning power is a company’s capability to generate profit from operations. The generation of profit is compared against the goods and services offered in a particular industry to check the earning power of different companies. Investors usually check the earning power of a company to see whether a company is worth to put the investment in they want in that company.
Earnings power is the company’s capability to derive profits from the invested capital in it by the investors. The profit, in this case, is considered after paying all obligations, such as loans, debt, and creditors. Banks usually check the earning power of a company before offering the company a loan.
How a Company’s Earning Power Determined?
A company’s earning power is determined by considering the following concepts −
- Earning Power Determined by Operating Income
The earning power of a company is determined by dividing operating income by total assets.
Operating Income
The operating income is the company’s net income excluding taxes and other financial liabilities. In simpler terms, it is the amount of profit a company makes minus operating expenses, such as depreciation, wages, and cost of goods sold (COGS).
The operating income is determined according to the profitability of a company over a specific period of time. Furthermore, it is also related to the capital a company employs to generate the profit from its operations. Operating income is, therefore, one of the most important items to measure the earning power of a company.
- Return on Assets (ROA) and Return on Equity (ROE)
A company’s earning power is determined by calculating either Return on Assets or Return on Equity.
Return on Assets (ROA)
Return on Asset is the company’s ability to generate profits based on a company’s assets. In other words, it shows how profitable the business is in generating income from its assets. The ROA is determined by dividing Net Income by Average Total Assets.
The ROA figure obtained tells how much profit the company can earn depending on the assets it has.
For example,
If the ROA is 4, it means that the company can earn a profit of Rs 4 for each rupee invested in the process. This means that ROA measures how many rupees it can earn for each rupee it invests in the operations to produce the goods and services.
ROA is often used to check the earning power of companies in a given industry because, with changing industries, the value of ROA varies widely.
Return on Equity (ROE)
Return on Equity is determined by comparing the net profits with the value of the equities. Equity is the fund the shareholders own in the company. ROE is also known as Return on Net Worth (RONW) or Return on Owners’ Investment (ROOI).
The ROE is determined by dividing net income by total equity for a given financial year. It is expressed as a percentage figure which shows the value of return for every 100 Rs of investment. In other words, the net income per 100 rupees of equity is the value of ROE.
For example,
Suppose company ABC generates a net income of Rs 1 crore in the fiscal year 2017. The shareholder’s equity at the end of fiscal 2016 was Rs 12 crore and Rs 14 crore at the end of 2017.
So,
$$\mathrm{Average\: Shareholder's\: Equity\, =\, \frac{Rs\, 12\, Cr + Rs\, 14\, Cr}{2}\, =\, Rs\, 13\, Cr}$$
So,
$$\mathrm{ROE =\, \frac{Rs\, 1\, Crore }{Rs\, 13\, Crore}\, =\, 0.77\, =\, 7.7\%}$$
Conclusion
Both Returns on Assets and Return on Equity use Net Income which is compared then to total assets and total equity, respectively. While Return on Assets offers an insight into a company’s ability to convert assets to Income given by ROA, the ability to generate income from using the total equity at hands of the company is given by ROE.
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