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8-1 8 CHAPTER Return on Invested Capital and Profitability Analysis
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8CHAPTER
Return on Invested Capital and Profitability Analysis
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Topic summary
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Return on Invested Capital
• Joint analysis is where one measure is assessed relative to another
• Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis
• Joint analysis is where one measure is assessed relative to another
• Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis
Importance of Joint Analysis
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Return on Invested Capital
ROI Relation
• ROI relates income, or other performance measure, to a company’s level and source of financing
• ROI allows comparisons with alternative investment opportunities
• Riskier investments expected to yield a higher ROI
• ROI impacts a company’s ability to succeed, attract financing, repay creditors,and reward owners
• ROI relates income, or other performance measure, to a company’s level and source of financing
• ROI allows comparisons with alternative investment opportunities
• Riskier investments expected to yield a higher ROI
• ROI impacts a company’s ability to succeed, attract financing, repay creditors,and reward owners
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Return on Invested Capital
Application of ROI
(2) measuring profitability
(3) Measure for planning and
control
(1)measuring managerial
effectiveness
(2)measuring Profitability
(3)measure for planning and
control
ROI is applicable to:
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Return on Invested Capital
Measuring Managerial Effectiveness
• Management is responsible for all company activities
• ROI is a measure of managerial effectiveness in business activities
• ROI depends on the skill, resourcefulness,ingenuity, and motivation of management
• Management is responsible for all company activities
• ROI is a measure of managerial effectiveness in business activities
• ROI depends on the skill, resourcefulness,ingenuity, and motivation of management
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Return on Invested Capital
Measuring Profitability
• ROI is an indicator of company profitability
• ROI relates key summary measures: profits with financing
• ROI conveys return on invested capital from different financing perspectives
• ROI is an indicator of company profitability
• ROI relates key summary measures: profits with financing
• ROI conveys return on invested capital from different financing perspectives
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Return on Invested Capital
Measuring for Planning and Control
ROI assists managers with:
• Planning• Budgeting• Coordinating activities• Evaluating opportunities• Control
ROI assists managers with:
• Planning• Budgeting• Coordinating activities• Evaluating opportunities• Control
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Components of ROI
• Return on invested capital is defined as:
Income
Invested Capital
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Components of ROI
Invested Capital Defined
• No universal measureof invested capital
• Different measures of invested capital reflect user’s different perspectives
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Components of ROI
Alternative Measures of Invested Capital
Common Measures:
• Net Operating Assets
• Stockholders’ Equity
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Components of ROI
• Perspective is that of the company as a whole • Called return on net operating
assets (RNOA)
RNOA: measures operating efficiency/
performancereflects return on net operating assets
(excluding financial assets/liabilities)Net income (exclude other income)
• Perspective is that of the company as a whole • Called return on net operating
assets (RNOA)
RNOA: measures operating efficiency/
performancereflects return on net operating assets
(excluding financial assets/liabilities)Net income (exclude other income)
Net Operating Assets
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Components of ROI
Common Equity Capital
• Perspective is that of common equity holders
• Captures the effect of leverage (debt) capital on equity holder return
• Excludes all debt financing and preferred equity
• Perspective is that of common equity holders
• Captures the effect of leverage (debt) capital on equity holder return
• Excludes all debt financing and preferred equity
net income less preferred dividendsaverage common equity
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Return on common equity
• The proportion of debt and equity financing of assets is a capital structure decision.
• A function of the degree to which the company is financed with debt.
• ROCE captures both the RNOA (operating return) and the effect of the financial leverage (use of debt vs equity in the capital structure/ non operating return).
• Exp: higher return on common shareholders’ equity compared to RNOA reflects the favourable affects of financial leverage.
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Components of ROI
Computing Invested Capital
• Usually computed using average capital available for the period
• Typically add beginning and ending invested capital amounts and divide by 2
• More accurate computation is to average interim amounts — quarterly or monthly
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Components of ROI
Adjustments to Invested Capital and Income Numbers
Many accounting numbers require analytical adjustment—see prior chapters
Some numbers not reported in financial statements need to be included
Such adjustments are necessary for effective analysis of return on invested capital
Many accounting numbers require analytical adjustment—see prior chapters
Some numbers not reported in financial statements need to be included
Such adjustments are necessary for effective analysis of return on invested capital
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Components of ROI
Return on Net Operating Assets -- RNOA
NOPAT
(Beginning NOA + Ending NOA) / 2
NOPAT
(Beginning NOA + Ending NOA) / 2
Where
• NOPAT = Operating income x (1- tax rate)
• NOA = net operating assets
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Operating and nonoperating activities
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Operating & non-operating activities based Accounting Equation
• Net operating assets (NOA) = Net Financial Obligations (NFO) + Stockholder’s equity (SE)
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Components of ROI
BALANCE SHEETOperating assets ..................... OA
Less operating liabilities ........ (OL)
Net operating assets.............. NOA
Financial liabilities .................. FL
Less financial assets ............. (FA)
Net financial obligations......... NFO
Stockholders’ equity................ SE
Net financing ................ NFO + SE
Operating and nonoperating activities - Distinction
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Components of ROI
Return on Common Equity -- ROCE
Net income - Preferred dividends
(Beginning equity + Ending equity) / 2
Net income - Preferred dividends
(Beginning equity + Ending equity) / 2
Where
• Equity is stockholder’s equity less preferred stock
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Analyzing Return on Assets-ROA
Disaggregating RNOA
Return on operating assets = Operating Profit margin x Operating Asset turnover
NOA Avg.
Sales
Sales
NOPAT
NOA Avg.
NOPAT
Operating Profit margin: measures operating profitability relative to sales
Operating Asset turnover (utilization): measures effectiveness in generating sales from operating assets
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Effect of Operating Leverage on RNOA
OA = operating assetsOLLEV = operating liabilities leverage ratio (operating liabilities / NOA)
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Effect of operating leverage
• NOA are reduced by increases in operating liabilities (OL), thus increasing net operating asset turnover.
• If the increase in OL does not effect NOPAT, RNOA will increased.
• OL generally do not entail a cost if used judiciously. Exp: increasing AP by delaying payment allows the company to use suppliers’ capital which is at low or no cost so long as the payment is not delayed too much.
• The firm has, if effect, profited from the use of its supplier’s capital, avoids the need to finance its operating assets with costly debt or equity capital.
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Profit Margin and Asset Turnover
• Profit margin and asset turnover are interdependent– Profit margin is a function of sales and operating
expenses• (selling price x units sold)
– Turnover is also a function of sales • (sales/assets)
$5,000,000 $10,000,000 $10,000,000$500,000 $500,000 $100,000
$5,000,000 $5,000,000 $1,000,00010% 5% 1%
1 2 1010% 10% 10%
NOPAT
Sales
Analysis of Return on Net Operating Assets
Return on net operating assets
NOA turnover
NOPAT margin
NOA
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Profit Margin and Asset Turnover
Relation between NOPAT Margin, NOA Turnover, and Return on Net Operating Assets
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Profit Margin and Asset Turnover
Company AA Company BB
SalesIncomeAssetsNOPAT marginNOA turnoverRNOA
$ 1,000,000$ 100,000$10,000,000
10%0.11%
$20,000,000$ 100,000$10,000,000
0.5%2.01%
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Profit Margin and Asset Turnover
Net operating Asset Turnover v/s Net operating Profit Margin for Selected Industries
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Analyzing Return on Assets-ROA
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Analyzing Return on Assets-ROA
Disaggregating Profit Margin
Operating profit margin (OPM) = NOPAT Sales
Pretax PM = Pretax sales PM + Pretax other PM
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Analyzing Return on Assets-ROA
• Gross Profit Margin: Reflects the gross profit as a percent of sales– Reflects company’s ability to increase or maintain
selling price– Declining margins may indicate that competition has
increased or that the company’s products have become less competitive, or both
• Selling Expenses• General and Administrative Expenses
Disaggregating Profit Margin
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Disaggregating Profit Margin
• Analysing changes in sales & cost of sales is useful in identifying major drivers of gross profit. Changes in gross profit often derive from one or a combination of the following:– Increase (decrease) in sales volume.– Increase (decrease) in unit selling price.– Increase (decrease) in cost per unit.
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Disaggregating Profit Margin
• Selling Expenses. – The importance of the relation between selling expenses
and revenues varies across industries and companies.
– In certain companies, selling expenses are primarily commissions that are highly variable, while in others they are largely fixed.
– Our analysis must attempt to distinguish between these variable and fixed components, which can then be usefully
analyzed relative to revenues.
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Analyzing Return on Assets-ROA
Disaggregation of Asset Turnover
• Asset turnover measures the intensity with which companies utilize assets
• Relevant measure is the amount of sales generated
Salesaverage net operating assets
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Analyzing Return on Assets-ROA
• Accounts Receivable turnover: Reflects how many times receivables are collected on average. – Accompanying ratio: Average collection period
• Inventories turnover: Reflects how many times inventories are collected on average – Accompanying ratio: Average inventory days outstanding
• Long-term Operating Asset turnover: Reflects the productivity of long-term operating assets
• Accounts Payable turnover: Reflects how quickly accounts payable are paid, on average – Accompanying ratio: Average payable days outstanding
Disaggregation of Asset Turnover
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Analyzing Return on Assets-ROA
Disaggregation of Asset Turnover
Accounts payable turnover = Cost of goods sold/Average accounts payable
Average payable days outstanding = Accounts payable/Average daily cost of goods sold
Net operating working capital turnover = Net sales/Average net operating working capital
Inventory turnover = Cost of goods sold/Average inventory
Average inventory days outstanding = Inventory/Average daily cost of goods sold
Long-term operating asset turnover = Sales/Average long-term operating assets
Accounts receivable turnover = Sales/Average accounts receivable
Average collection period = Accounts receivable/Average daily sales
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Analysing Return on Common Equity-ROCE
• Shareholders have claims on the residual earnings of a company only after all other financing sources are paid.
• Accordingly, the return on shareholders’ equity is most important to common shareholders.
• The relation between ROCE and RNOA is also important as it bears on the analysis of a company’s success with financial leverage
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Analyzing Return on Common Equity-ROCE
where ROCE is equal to net income available to common shareholders (after preferred dividends) divided by the beginning-of-period common equity
This can be restated in terms of future ROCE:
Role in Equity Valuation
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Analyzing Return on Common Equity-ROCE
Disaggregating ROCE
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Analyzing Return on Common Equity-ROCE
• Leverage refers to the extent of invested capital from other than common shareholders
• If suppliers of capital (other than common shareholders) receive less than ROA, then
common shareholders benefit; the reverse occurs when suppliers of capital receive more than ROA• The larger the difference in returns between common equity and other capital suppliers, the more successful (or unsuccessful) is the trading on the equity
• Leverage refers to the extent of invested capital from other than common shareholders
• If suppliers of capital (other than common shareholders) receive less than ROA, then
common shareholders benefit; the reverse occurs when suppliers of capital receive more than ROA• The larger the difference in returns between common equity and other capital suppliers, the more successful (or unsuccessful) is the trading on the equity
Leverage and ROCE
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Financial Leverage
• The first component of the financial leverage effect is the degree of financial leverage (LEV), measured by the relative amounts of NFO and stockholders’ equity used by the company to finance its NOA.
• The second component is the spread, the RNOA less the net financial return (NFR), where NFR is the average net return on financial (nonoperating) liabilities and assets.
• NFO can be either + (reflecting nonoperating liabilities > nonoperating assets) or - (reflecting nonoperating assets > nonoperating liabilities), so can NFE be + (reflecting interest expense > investment returns) or - (reflecting investment returns > interest expense).
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• Return on common equity (ROCE) consists of both an operating component (RNOA) and a nonoperating component (LEV x Spread). This operating and non operating distinction is important for several reasons:
– The vast majority of companies provide goods and services to customers as their primary business. This is where their expertise lies. Although finance divisions in companies are staffed with highly competent personnel, we want those companies to excel in their core competencies, and not to have poor operating performance masked by good financial performance.
– Operating activities have the most pronounced and long-lasting effects on company value. Research confirms that the stock price multiple on operating earnings is many times that on financial earnings.
– Although companies can realize an increase in ROE through judicious use of financial leverage, debt payments (interest and principal) are contractual obligations that must be met in good times and in bad. Increasing debt, therefore, increases the risk of default should cash flows decline, and default can have disastrous consequences for the firm, including bankruptcy.
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Analyzing Return on Common Equity-ROCE
Alternate View of ROCE Disaggregation
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Analyzing Return on Common Equity-ROCE
equity rs’stockholde common Averagepayout Dividend dividends Preferred income Net = rate growth Equity
Assessing Equity Growth
• Assumes earnings retention and a constant dividend payout
• Assesses common equity growth rate through earnings retention
• Assumes earnings retention and a constant dividend payout
• Assesses common equity growth rate through earnings retention
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Analyzing Return on Common Equity-ROCE
Assessing Equity Growth
Assumes internal growth depends on both earnings retention and return earned on the earnings retained
Assumes internal growth depends on both earnings retention and return earned on the earnings retained
rate)Payout (1 ROCE = rategrowth equity eSustainabl
