Basic earnings power

Basic earnings power
See also
Net income margin Bank efficiency ratio Capital gearing Combined Ratio Economic Value Added - EVA Return on sales Activity ratios Solvency ratios Operating cash flow ratio

Basic earnings power (BEP) is a measure that illustrates the power to generate profits that the company's assets have before tax and debt service. This ratio does not take into account tax conditions and various levels of financial leverage what allows to compare companies which otherwise would not be possible to compare.

Basic earnings power is used as a ratio measuring the effectiveness of operations, however, to fully analyze the issues related to asset management, BEP should be combined in conjunction with other turnover indicators

Formula of the basic earnings power

Basic earnings power illustrates the ratio of earnings before interest and taxation to total asset of company and it is expressed by the formula:

$BEP={\frac {EBIT}{Revenues}}\cdot {\frac {Revenues}{Total\ assets}}={\frac {EBIT}{Total\ assets}}$

Where:

• BEP - basic earnings power
• EBIT - earnings before deducting interest and taxes

Basic earnings power can be also expressed as quotient operating profit margin and total asset turnover:

$BEP=Operating\ profit\ margin\cdot Total\ asset\ turnover$

Where:

• Operating profit margin is calculated from the formula:

$Operating\ profit\ margin={\frac {Operating\ income}{Revenues}}$

• and total asset turnover from the formula:

$Total\ asset\ turnover={\frac {Revenues}{Average\ total\ assets}}$

Example and interpretation

"Example comapny" has EBIT (earnings before interest and taxes) in the amount of US$140,125 and total assets in the amount of US$700,625. This gives a basic earnings power ratio (BEP) on the level of 0.20

$BEP={\frac {EBIT}{Total\ assets}}={\frac {140,125}{700,625}}=0.20$

BEP can be also expressed as a percentage, then it is:

$BEP={\frac {EBIT}{Total\ assets}}\cdot 100\%={\frac {140,125}{700,625}}\cdot 100\%=20\%$

This result tells us that company generated US$20 of operating profit from every US$100 invested in total assets. The result of this indicator can be compareed with results of industry competitors "to gauge the operational effectiveness of generating profits".

Advantages of Basic earnings power

Basic earnings power (BEP) offers several advantages for investors and analysts looking to evaluate the profitability of a company. It is useful in comparing companies with different tax rates and different levels of financial leverage. Specifically, the advantages of BEP include:

• The ability to compare companies that would otherwise be difficult to compare. BEP provides an unbiased comparison of companies by normalizing the effect of taxes and financial leverage.
• BEP provides insight into the company's ability to generate profits from its assets. This allows investors to evaluate the company's ability to generate profits at different levels of financial leverage and different tax rates.
• BEP can be used to determine the optimal capital structure for the company. By understanding the company's ability to generate profits at different levels of financial leverage and different tax rates, investors can determine the optimal capital structure that will generate the highest returns.
• BEP can be used to identify undervalued companies. By comparing a company's BEP with other companies in the same industry, investors can identify companies that are undervalued relative to their peers.

Limitations of Basic earnings power

Basic earnings power is a useful tool to measure the potential profitability of a company's assets, however, there are several limitations to consider when using it. These include:

• Ignoring the impact of taxes and debt service: BEP does not take into account taxes, interest payments, and other costs associated with debt, which can have a significant impact on a company's profitability.
• BEP does not take into account other sources of income such as capital gains, dividends, or royalties, which can also affect a company's profitability.
• BEP does not account for changes in the market or in the economy, which can have a significant effect on a company's profitability.
• BEP does not take into account changes in the company's management or strategy, which can also have a significant impact on profitability.
• BEP does not take into account changes in the company's competitive environment, which can also have a significant effect on profitability.

Other approaches related to Basic earnings power

To further measure a company's earnings power, there are several other approaches that could be taken into account. These approaches include:

• Economic Value Added (EVA): This is a measure of the economic profit created by a company, which is calculated by subtracting a required return from the company's operating profit after taxes.
• Cash Flow Return on Investment (CFROI): This is a measure of the company's overall return on investment, which is calculated by subtracting the cost of capital from the company's free cash flow.
• Price-to-Earnings Ratio (P/E Ratio): This is a measure of the company's share price relative to its earnings per share.
• Price-to-Book Ratio (P/B Ratio): This is a measure of the company's share price relative to its book value per share.

In summary, there are several approaches that can be used to measure a company's earnings power, such as EVA, CFROI, P/E ratio, and P/B ratio. Each approach has its own merits, and can provide a useful insight into the company's overall financial performance.

References

• Fabozzi F. J., (2016), Entrepreneurial Finance and Accounting for High-Tech Companies, MIT Press, London
• Leon S. M., (2015), Financial Intelligence for Supply Chain Managers: Understand the Link between Operations and Corporate Financial Performance, FT Press, Old Tappan
• Masoom K., (2013), The Entreprenaur’s Dictionary of Business and Financial Terms, Trafford Publishing, Singapore,
• Rist M. & Pizzica A. J., (2014), Financial Ratios for Executives: How to Assess Company Strength, Fix Problems, and Make Better Decisions, Springer, Berlin

Author: Wojciech Musiał