Basic Earning Power Ratio

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

The Basic Earning Power (BEP) ratio refers to a financial metric used for the evaluation of a business's operational efficiency in employing its overall assets for income generation. It is computed as a percentage value by dividing earnings before interest and taxes (EBIT) from the average total assets, multiplied by 100.

Since it is a profitability ratio, a higher BEP ratio suggests greater efficiency in utilizing assets for profitability. As a result, this ratio serves as a critical tool for various stakeholders, including investors, analysts, and management, in assessing a company's financial performance. However, the figures may significantly differ from company to company or industry to industry.

What Is Basic Earning Power Ratio?

The Basic Earning Power (BEP) ratio is a financial metric to gauge a company's capacity to generate operational income by utilizing its assets.
The BEP ratio can be expressed mathematically as a percentage that is obtained by dividing the EBIT with the total assets.
Hence, it offers valuable insights into a business's operational efficiency and profitability without considering the impact of financial leverage. Moreover, it is easy to evaluate, analyze, and compare.
However, since the BEP ratio is a mere indicator and lacks self-sufficiency in concluding, it should be used in conjunction with other financial metrics to ensure a comprehensive analysis of the company's financial well-being.

Basic Earning Power Ratio Explained

The basic earning power ratio offers valuable insights into a company's operational efficiency and its capacity to generate profits from its assets. This ratio, which examines the relationship between operating income and total assets, serves as a critical metric for evaluating how effectively a company utilizes its resources to generate earnings without factoring in financial leverage.

The easy calculation and comprehension for quick financial analysis make this ratio quite favorable. Moreover, it enables direct comparisons of the earning power among different firms, as it remains unaffected by tax rates or interest expenses.

Moving on to the basic earning power ratio analysis interpretation, a higher value implies that the company efficiently generates earnings from its asset base. On the contrary, a lower percentage indicates inefficiencies in asset utilization or lower profitability relative to the scale of the company's asset portfolio. However, to derive more meaningful conclusions, it is crucial to compare the ratio against industry benchmarks and evaluate the performance over an extended period.

Indeed, it is just an indicative factor and requires further analysis to make sense. Another major setback for this ratio is that it concentrates solely on earnings before interest and taxes (EBIT), omitting factors such as depreciation and changes in working capital. Moreover, this measure is not self-sufficient, and therefore, for a broad analysis of a firm's financial health, it should be used together with other financial indicators. Further, the companies must adopt measures to boost profitability while keeping total assets in check to promote their operational efficiency.

Formula

The basic earning power ratio analysis interpretation is a profitability measure that analyses the earning potential of a business through the efficient employment of its overall assets. Given below is the equation to compute the BEP ratio:

BEP Ratio = (EBIT / Total Assets) * 100

Here,

Earnings Before Interest and Taxes (EBIT) = Net Income + Interest + Taxes, or EBIT = Gross Profit – Operating Expenses. It is the operating profit of the business.
Total assets is the sum of all the assets owned, found as the balance sheet figure available on the right side. It is also calculated as Total Assets = Current Assets + Non-Current Assets.

Another formula for the BEP ratio is:

BEP Ratio = Operating Profit Margin * Asset Turnover

Here,

Operating Profit Margin = EBIT / Turnover or Sales
Asset Turnover = Turnover or Sales / Assets

Examples

A company's capital structure significantly influences its profitability ratios. Thus, BEP is often low for capital-intensive industries and high for labor-intensive industries. Let us now discuss some examples to understand its computation:

Example #1

Suppose a company records annual net earnings of $250,000, interest payments of $50,000, and taxes worth $75,000. At the same time, the company possesses total assets amounting to $2 million. Determine the BEP ratio.

Solution:

BEP Ratio = (EBIT / Total Assets) * 100

EBIT = Net Income + Interest + Taxes

EBIT = $250,000 + $50,000 + $75,000 = $375,000

BEP Ratio = (375,000 / 2,000,000) * 100 = 18.75%

Hence, the company generates 18.75% of operating profits from its overall asset employment, which indicates optimal resource utilization.

Example #2

Given below are the extracted figures of Dutch Bros Inc.'s EBIT and Total Assets for the trailing 12 months from its income statement and balance sheet:

Now, let us determine the BEP ratio:

BEP Ratio = (EBIT / Total Assets) * 100

BEP Ratio = (34,333 / 1,186,360) * 100 = 2.89%

Hence, the USA-based drive-through coffee chain has a 2.89% BEP ratio, which is owing to its rapid growth as a brand in the restaurant industry.

Frequently Asked Questions (FAQs)

1. What is a good basic earning power ratio?

There is no ideal BEP ratio, as it varies from industry to industry; however, a higher ratio is often considered favorable.

2. How to improve basic earning power ratio?

To enhance the BEP ratio, the company should concentrate on elevating operational income without substantially growing its assets. The management should:
- Implement strategies such as increasing sales through effective marketing,
- Controlling costs without compromising quality, optimizing asset utilization,
- Improving productivity through employee training and the incorporation of new technology,
- Diversifying into new markets or product lines and
- Managing debt efficiently.

3. Why is the basic earning power ratio useful?

The BEP metric is valuable in gauging a company's operational competency and profitability with relevance to its assets. It is significant for the following reasons:
- A higher ratio suggests efficient resource utilization in profit generation.
- It facilitates comparisons between companies within the same industry.
- It serves as an indicator of management effectiveness in generating profits through operational activities.
- Investors analyze the BEP to comprehend the company's operational performance before investing.
- It facilitates decision-making on resource allocation, cost management, and overall operational strategies.
- The BEP ratio helps in evaluating the risk associated with a company's operations.