Methods for measuring profitability

The focus of this research is on the financial performance with the target to analyse primarily the profitability of the DSOs. When analysing the performance or profitability of any company, it is valuable to include multiple years for review in order to avoid skewed results caused by anomalous short-term events (Seppänen 2011, 93-96). The investigation period of the research is 2014-2019, which is divided between two different regulatory periods, the third (2012-2015) and fourth (2016-2019). The research method of the study is a statistical analysis. Niskanen &

Niskanen (2003, 111) state that the two main types of statistical comparison are

cross-sectional and time-series analysis. In cross-sectional analysis the information of at least two different companies are compared with each other at a certain period of time. While in time-series analysis, one single company’s information is followed for a longer period of time, which allows to make conclusions about the financial development and possible trends related to performance of a company. This research is mixture of both analysis methods, as it exploits the information about the companies within the distribution operations and their peers for a time period of several years. (Seppänen 2011, 96–97; Niskanen & Niskanen 2003, 20)

The validity of a research is evaluated based on how well the chosen research methods are measuring the phenomena under assessment. The wide selection of performance indicators and margins was evaluated thoroughly in the previous chapter - based on the availability of reliable and comparable data as well as suitability regarding the DSOs and the peer companies the author limited the focus of analysis on relative profitability metrics and the absolute measures were excluded.

Exclusively liquidity and solvency measures are also excluded from the research.

The chosen relative profitability indicators are two of the traditional margin metrics (operating margin and profit margin), and three return metrics Return on Assets (ROA), Return on Equity (ROE), and Return on Invested capital (ROI).

Operating margin is considered as a suitable tool for analysing capital-intensive industries, which typically are financed with considerable amounts of debt. When comparing the performance of two capital intensive companies, EBIT% is a sensible measure as it captures the cost of the fixed assets. Profit margin in turn is considered as the ultimate measure of profitability for a company (Brealey & Myers 2000). In comparison to gross profit margin, the profit margin is far more definitive indicator of profitability as it includes the total of expenses.

ROA is a suitable indicator of profitability for DSOs, as the assets, i.e., the network is an integral part to generate revenue. However, the ROA, as other financial ratios, can be manipulated with accounting. If a DSO utilizes an accelerated depreciation method, for instance the book value of assets reduces and thus boosts the value of ROA. In Figure 11 the industry average performance in terms of ROA of three

different business sectors from the MSCI All Countries World Index is presented.

The index is designed to track broad global performance of the equity markets.

(MSCI Inc, n.d.) The data concerning the performance of the indices is attained from Factset. The long-term average ROA of the MSCI Utility sector is 2.75 and during the research period 2014-2019 2.71 percent.

Figure 11 Average Return on Assets of MSCI AC World sector indices

The leverage of debt and taxes are included in the calculation of ROE. Thus, especially during an upturn, a company with a high debt to equity ratio gets a higher ROE, simply due to the fixed interest on debt and its lower cost of capital than on equity. In other words, a high ROE may be a consequence of “excess” debt – if the DSO has a high debt to equity ratio, ROE increases as the equity is equal to debt deducted from assets. Utility companies, such as the DSOs, tend to have a large share of assets and debt on their balance sheet compared to relatively smaller amount of net income. In Figure 12 is presented the performance in terms of ROE of three sectors from MSCI All Countries World Index. The long-term average ROE of the MSCI AC World Utility index is 10.02 percent and in 2014-2019 9.64 percent.

To illustrate the industry averages presented in Figure 12, the data is attained from Factset.

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Figure 12 Average Return on Equity of MSCI AC World sector indices

Due to its versatility, the return on invested capital is one of the most common profitability measures among analysts (Brealey & Myers 2000). As stated in the previous chapter, ROI assesses the earnings of a company in relation to its investments, including both, debt and equity. In capital intensive businesses, such as the electricity distribution, where the balance sheets tend to be substantial, ROI is an extremely valuable measure of performance (Borneman 2017). The return on invested capital is In Figure 13 the performance in terms of ROI of the three sectors from MSCI All Countries World Index is presented. The data concerning the performance of the indices is attained from Factset to represent the industry averages. The long-term average of the MSCI AC World utilities index is 4.75 percent and during the research period 4.63 percent.

Figure 13 Average Return on Investment of MSCI AC World sector indices 0%

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 MSCI AC World / Utilities MSCI AC World / Telecommunication Services MSCI AC World / Industrials