8-1

Return on Invested Capital and

Profitability Analysis

CHAPTER

8-2

Topic summary

8-3

Return on Invested Capital

Importance of Joint Analysis
Joint
Joint analysis
analysis is
is where
where one
one measure
measure is
is
assessed
assessed relative
relative to
to another
another
Return
Return on
on invested
invested capital
capital (ROIC)
(ROIC) or
or
Return
Return on
on Investment
Investment (ROI)
(ROI) is
is an
an important
important
joint
joint analysis
analysis

8-4

Return on Invested Capital

ROI Relation
ROI
ROIrelates
relatesincome,
income, or
orother
otherperformance
performance measure,
measure,
to
toaacompanys
companyslevel
leveland
andsource
sourceof
of financing
financing
ROI
ROIallows
allowscomparisons
comparisonswith
withalternative
alternative investment
investment
opportunities
opportunities
Riskier
Riskierinvestments
investmentsexpected
expected to
toyield
yieldaahigher
higherROI
ROI
ROI
ROIimpacts
impactsaacompanys
companysability
ability
to
tosucceed,
succeed, attract
attractfinancing,
financing,
repay
repaycreditors,and
creditors,andreward
rewardowners
owners

8-5

Return on Invested Capital

Application of ROI
ROI is applicable to:
(1)
(2) (2)
(3) (3)
measuring measuring
measuring Measure
measure
for for
managerial profitability
Profitabilityplanning
planning
andand
effectiveness
control
control

8-6

Return on Invested Capital

Measuring Managerial Effectiveness

Management
Management is
is
responsible
responsible for
for all
all
company
company activities
activities
ROI
ROI is
is aa measure
measure of
of managerial
managerial
effectiveness
effectiveness in
in business
business activities
activities
ROI
ROI depends
depends on
on the
the skill,
skill, resourcefulness,
resourcefulness,
ingenuity,
ingenuity,and
and motivation
motivation of
of management
management

8-7

Return on Invested Capital

Measuring Profitability

ROI
ROI is
is an
an indicator
indicator of
of company
company
profitability
profitability
ROI
ROI relates
relates key
key summary
summary
measures:
measures: profits
profits with
with financing
financing
ROI
ROI conveys
conveys return
return on
on invested
invested
capital
capital from
from different
different financing
financing perspectives
perspectives

8-8

Return on Invested Capital

Measuring for Planning and Control

ROI
ROI assists
assists managers
managers with:
with:
Planning
Planning
Budgeting
Budgeting
Coordinating
Coordinating activities
activities
Evaluating
Evaluating opportunities
opportunities
Control
Control

8-9

Components of ROI
Return on invested capital is defined as:
Income
Invested Capital

8-10

Components of ROI
Invested Capital Defined

No universal measure
of invested capital
Different measures of
invested capital reflect
users different
perspectives

8-11

Components of ROI
Alternative Measures of Invested Capital
Common Measures:

Net Operating Assets

Stockholders Equity

8-12

Components of ROI
Net Operating Assets
Perspective
Perspectiveis
isthat
that of
of the
thecompany
company
as
asaawhole
whole
Called
Called return
return on
on net
net operating
operating
assets
assets (RNOA)
(RNOA)

RNOA:
RNOA:

measures
measuresoperating
operatingefficiency/
efficiency/

performance
performance

reflects
reflectsreturn
returnon
onnet
netoperating
operatingassets
assets
(excluding
(excludingfinancial
financialassets/liabilities)
assets/liabilities)

Net
Netincome
income(exclude
(excludeother
otherincome)
income)

8-13

Components of ROI
Common Equity Capital
Perspective
Perspective is
is that
that of
of common
common
equity
equity holders
holders
Captures
Captures the
the effect
effect of
of leverage
leverage
(debt)
(debt) capital
capital on
on equity
equity holder
holder
return
return
Excludes
Excludes all
all debt
debt financing
financing and
and
preferred
preferred equity
equity
net income less preferred dividends
average common equity

8-14

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.

8-15

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

8-16

Components of ROI
Adjustments to Invested Capital and Income Numbers

Many
Manyaccounting
accountingnumbers
numbersrequire
require
analytical
analyticaladjustmentsee
adjustmentseeprior
prior chapters
chapters

Some
Somenumbers
numbersnot
notreported
reported in
in financial
financial
statements
statementsneed
need to
tobe
beincluded
included

Such
Suchadjustments
adjustmentsare
arenecessary
necessaryfor
for
effective
effectiveanalysis
analysisof
ofreturn
returnon
oninvested
invested
capital
capital

8-17

Components of ROI
Return on Net Operating Assets -- RNOA

NOPAT
NOPAT
(Beginning
(Beginning NOA
NOA ++ Ending
Ending NOA)
NOA) // 22
Where
NOPAT = Operating income x (1- tax rate)
NOA

= net operating assets

8-18

Operating and nonoperating activities

8-19

Operating & non-operating activities based

Accounting Equation
Net operating assets (NOA) = Net Financial
Obligations (NFO) + Stockholders equity (SE)

8-20

Components of ROI
Operating and nonoperating activities - Distinction
BALANCE SHEET
Operating assets ..................... OA Financial liabilities .................. FL
Less operating liabilities ........ (OL) Less financial assets ............. (FA)
Net financial obligations......... NFO
Stockholders equity................ SE
Net operating assets..............
NOA

Net financing ................ NFO + SE

8-21

Components of ROI
Return on Common Equity -- ROCE

Net
Net income
income -- Preferred
Preferred dividends
dividends
(Beginning
(Beginning equity
equity ++ Ending
Ending equity)
equity) // 22
Where
Equity is stockholders equity less preferred
stock

8-22

Analyzing Return on Assets-ROA

Disaggregating RNOA
Return on operating assets =
Operating Profit margin x Operating Asset turnover

NOPAT
NOPAT
Sales

Avg. NOA
Sales Avg. NOA
Operating Profit margin: measures operating profitability
relative to sales
Operating Asset turnover (utilization): measures effectiveness
in generating sales from operating assets

8-23

Effect of Operating Leverage on RNOA

OA
= operating assets
OLLEV = operating liabilities leverage ratio
(operating liabilities / NOA)

8-24

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 suppliers capital,
avoids the need to finance its operating assets with costly debt or
equity capital.

8-25

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)

8-26

Profit Margin and Asset Turnover

Relation between NOPAT Margin, NOA Turnover, and
Return on Net Operating Assets

8-27

Profit Margin and Asset Turnover

Sales
Income
Assets
NOPAT margin
NOA turnover
RNOA

Company AA

Company BB

$ 1,000,000
$ 100,000
$10,000,000
10%
0.1
1%

$20,000,000
$ 100,000
$10,000,000
0.5%
2.0
1%

8-28

Profit Margin and Asset Turnover

Net operating Asset Turnover v/s
Net operating Profit Margin for Selected Industries

8-29

Analyzing Return on Assets-ROA

8-30

Analyzing Return on Assets-ROA

Disaggregating Profit Margin

NOPAT
Operating profit margin (OPM) =
Sales
Pretax PM = Pretax sales PM + Pretax other PM

8-31

Analyzing Return on Assets-ROA

Disaggregating Profit Margin

Gross Profit Margin: Reflects the gross profit as

a percent of sales
Reflects companys ability to increase or maintain
selling price
Declining margins may indicate that competition has
increased or that the companys products have
become less competitive, or both

Selling Expenses
General and Administrative Expenses

8-32

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.

8-33

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.

8-34

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
Sales
average net operating assets

8-35

Analyzing Return on Assets-ROA

Disaggregation of Asset Turnover
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

8-36

Analyzing Return on Assets-ROA

Disaggregation of Asset Turnover

8-37

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 companys success with
financial leverage

8-38

Analyzing Return on Common Equity-ROCE

Role in Equity Valuation

This can be restated in terms of future ROCE:

where ROCE is equal to net income available to common shareholders

(after preferred dividends) divided by the beginning-of-period common
equity

8-39

Analyzing Return on Common Equity-ROCE

Disaggregating ROCE

8-40

Analyzing Return on Common Equity-ROCE

Leverage and ROCE
Leverage
Leverage refers
refers to
to the
the extent
extent of
of invested
invested capital
capital
from
from other
otherthan
thancommon
common shareholders
shareholders
IfIf suppliers
suppliers of
of capital
capital (other
(other than
than common
common
shareholders)
shareholders) receive
receive less
less than
than ROA,
ROA, then
then
common
common shareholders
shareholders benefit;
benefit; the
the reverse
reverse
occurs
occurs when
when suppliers
suppliers of
of capital
capital receive
receive more
more
than
thanROA
ROA
The
Thelarger
larger the
thedifference
differencein
inreturns
returnsbetween
between
common
commonequity
equityand
andother
othercapital
capitalsuppliers,
suppliers,the
the
more
moresuccessful
successful(or
(or unsuccessful)
unsuccessful)isisthe
thetrading
trading
on
onthe
theequity
equity

8-41

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).

8-42

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.

8-43

Analyzing Return on Common Equity-ROCE

Alternate View of ROCE Disaggregation

8-44

Analyzing Return on Common Equity-ROCE

Assessing Equity Growth
Equity growth rate = Net income Preferred dividends Dividend payout
Average common stockholders equity

Assumes
Assumesearnings
earningsretention
retention
and
and aaconstant
constant dividend
dividend
payout
payout
Assesses
Assessescommon
common equity
equity
growth
growthrate
ratethrough
through
earnings
earnings retention
retention

8-45

Analyzing Return on Common Equity-ROCE

Assessing Equity Growth
Sustainable equity growth rate = ROCE (1Payout rate)

Assumes
Assumesinternal
internalgrowth
growth
depends
dependson
on both
bothearnings
earnings
retention
retentionand
andreturn
return earned
earned on
on
the
theearnings
earningsretained
retained