Basic Earning Power Ratio

The basic earning power ratio is the relationship between the earning power of a company and its assets.

Basic Earning Power Ratio – Rationale

Total Assets

To generate revenue, an organization needs to have certain assets.

Depending upon the industry and nature of the business, the volume and value of assets will be determined.

The financial implication of Assets: –

• The cost of fixed assets is capital in nature. So, we treat it as part of the Balance Sheet and not the Income Statement.
• Assets are used for production. Hence they are subjected to wear and tear.
• As a result, we depreciate tangible assets and amortize intangible assets

EBIT (Earnings Before Intrest and Tax)

• Earnings Before Interest and Tax is the net margin a company has made during the year.
• The net margin includes both Operating Revenue and Non-operative Revenue
• It measures the profitability of the Organization

Formula of Basic Earnings Power Ratio

Breakup of Formula

Let us try to analyze the breakup of the BEP Ratio. It is the product of Operating Profit Margin & Total Assets Turnover.

• Operating Profit Margin = EBIT / Turnover (Sales). The appropriate representation for Operating Profit is in percent.
• Assets Turnover = Turnover (Sales) / Assets

Basic Earning Power Ratio – Interpretation

Basic Earning Power Ratio is the relationship between the earning power of a company in relation to the company’s Assets.

A straightforward interpretation of the BEP Ratio is that the assets are used efficiently.

The higher the BEP Ratio, the better.

Limitations of BEP

• Firstly, BEP is not ultimate. Like all the other financial ratios, it needs to be further analyzed.
• More importantly, it is an indicative factor.
• To conclude, the inference can be made only by combining other ratios and comparing them with Industry Standards.

ROA (Return on Assets) vs. Basic Earning Power Ratio

Return on Assets is the relationship between Net Income and Total Assets
Unlike BEP, RoA considers Operational Income and excludes non-operational income.

Refer to RETURN ON ASSETS for more details.

Illustration

For instance, let us assume an investor ‘X’ would like to invest his surplus with either ‘A’ or ‘B.’ Two friends’ ‘A’ and ‘B’ started their own business on 01st January 20xx by investing $ 500,000. They both took two premises on rent for $2,000.

Friend ‘A’ started her own restaurant. She purchased the kitchenware, stoves, chairs, and tables, which cost her $ 300,000. For the first quarter, her sales were $ 20,000, and the expenses were around $8,000.  ‘A’ earned an interest of 6 % on $ 200,000 left in the Bank.

‘B’ has started her consultancy firm that designs websites. She leased an office, purchased a laptop, few essential software that cost her $ 50,000. For the first quarter, she earned a revenue of $ 20,000, and her expenses were around $ 8,000. ‘B’ earned an interest of 6 % on $ 450,000 left in the Bank.

Assuming an investor does not have any personal preferences, which one should he prefer and why?

A quick summary of the Quarter Transactions

Income Statement

Representation of the above data  to arrive at a Profit 

Balance Sheet

Representation of the above data to derive the Financial Position

Calculation of Ratios

Calculation of Basic Earning Ratio can be as follows:

BEP (Basic Earning Power Ratio)  =  EBIT / Fixed Assets 
=  $ 5,500 / $292,500 for Friend A = 0.0188 or (1.88%)
=  $ 15,500 / $ 48,750 for Friend B  = 0.3179 or (31.79%)

RoA (Return of Assets)   =  Operating Income / Fixed Assets 
=  $ 2,500 / $292,500 for Friend A = 0.0085 or (00.85%)
=  $ 8,750 / $ 48,750 for Friend B  = 0.1795 or (17.95%)

As discussed above, the higher the BEP Ratio, the better the company assets are utilized to generate earnings. Hence, we can conclude that the business of Friend B is better for investment as it gives substantially higher returns. In these competing investment scenarios, the BEP Ratio is 0.0188:0.3179 (A: B).

You can also use our calculator – Basic Earning Power Ratio Calculator

Conclusion

Basic Earning Power Ratio is a simple calculation for establishing the relationship between EBIT and the assets. In other words, it shows the earning power of the assets deployed by the entity.