What is earning power? Definition and examples
Earning power is a company’s ability to generate profit. Specifically, its ability to generate profit from its operations. Investors and analysts calculate earning power to determine whether a company is worth investing in. Earning power refers to either an organization’s or person’s ability to generate earnings in return for goods or services.
We calculate earning power by dividing operating income by total assets.
A company’s operating income is its net income, not including the impact of any taxes or financial activity. In other words, the amount of profit a company makes from its business operations minus operating expenses such as wages, depreciation, and cost of goods sold.
We measure it according to the profit the business generates over a specific period. Additionally, we measure it in relation to the capital the company employed.
Definitions.USLegal.com has the following definition of the term:
“Earning power is the ability of a business to earn a profit on invested capital after paying owners and employees, servicing obligations, and fully recognizing its costs while following good accounting practices.”
Before deciding whether to approve a business loan, banks look at a company’s earning power.
We can write the term in both its singular and plural forms, i.e., earning power or earnings power.
Earning power – ROA and ROE
We can determine a company’s ability to generate profits by analyzing its ROA and ROE. ROA and ROE stand for return on assets and return on equity respectively.
Return on assets
ROA shows the percentage of how profitable a business’ assets are in generating income. ROA equals net income divided by average total assets.
The resulting figure tells us what the company can do with what it has. In other words, how many dollars it derives from each dollar of assets that it has under its control.
Investors often use ROA to compare companies in the same industry. When comparing companies, they must be in the same industry, because good and bad ROAs vary considerably between industries.
Return on equity
ROE compares a business’ net profit directly to the value of its equities. Equity, in this context, refers to what a shareholder owns in a corporation.
We often refer to ROE as ‘return on net worth‘ or ‘return on owners’ investment.’
We calculate ROE by dividing a company’s net income for the fiscal year by total equity. The result is a percentage.
Let’s suppose a furniture company generates a net income of $1 million in fiscal 2018. The shareholders’ equity at the end of 2017 was $12 million, and $14 million at the end of fiscal 2018.
Average Shareholders’ Equity = ($12 million + $14 million) ÷ 2 = $13,000,000.
ROE = $1 million ÷ $13 million = 0.077 or 7.7%.