Basic Earning Power Ratio is the relationship between the earning power of a company in relation to the Assets of the company.
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 Balance Sheet and not 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 INTEREST 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
BASIC EARNING POWER RATIO – INTERPRETATION
Basic Earning Power Ratio is the relationship between the earning power of a company in relation to the Assets of the company.
A straightforward interpretation of 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 need to be further analyzed.
- More importantly, it is an indicative factor.
- To conclude, the inference can be made only with combining other ratios, and comparing with Industry Standards
BREAKUP OF BASIC EARNING POWER RATIO
In this section, let us try to analyze the breakup of 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 per cent.
- Assets Turnover = Turnover (Sales) / Assets
- BEP Ratio = Operating Profit Margin * Assets Turnover Ratio
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 the Operational Income and excludes non-operational income
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 that cost her $ 300,000. For the first quarter, her sales are $ 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 own 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 are 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 Profit
BALANCE SHEET
Representation of the above data to derive the Financial Position
CALCULATION OF RATIOS
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 is giving substantially higher returns. The BEP Ratio in these competing investment scenario is 0.0188:0.3179 (A: B).
TO CONCLUDE
Basic Earning Power Ratio is a simple calculation done by an organization to establish the relationship between EBIT and the Assets. In other words, it shows the earning power of the assets deployed by the entity.
