1. Return on Invested Capital8
CHAPTER

2. Return on Invested Capital Importance of Joint Analysis
• Joint analysis is where one measure is
assessed relative to another
• Return on invested capital (ROI) is an important
joint analysis 2 2

3. 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, and with same opportunity over time
Riskier investments are expected to yield a higher ROI
ROI impacts a company’s ability to succeed, attract financing, repay creditors,and reward owners 2 2

4. Return on Invested Capital
Application of ROI
ROI is applicable to:
(1) evaluating managerial effective-
ness
(2) assessing profitability
(3)
earnings forecasting
(4)
planning and control 2 2

5. Return on Invested Capital Evaluating 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 2 2

6. 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 2 2

7. Return on Invested Capital Assists in Forecasting Earnings
• ROI links past, current, and forecasted earnings with invested capital
• ROI adds discipline to forecasting
• ROI helps identify
optimistic or pessimistic
forecasts
• ROI aids in evaluating prior forecast performance 2 2

8. Return on Invested Capital For Planning and Control
ROI assists managers with:
• Planning
• Budgeting
• Coordinating activities
• Evaluating opportunities
• Control 2 2

9. Components of ROI Definition Return on invested capital is defined as:2 2

10. Invested Capital Defined
Components of ROI
Invested Capital Defined
• No universal measure
of invested capital exists
• Different measures of invested capital reflect different financiers’ perspectives 2 2

11. Alternative Measures of Invested Capital
Components of ROI
Alternative Measures of Invested Capital
Five Common Measures:
• Total Assets
• Long-Term Debt Plus Equity
• Common Equity
• Market Value of Invested Capital (debt and equity)
• Investor Invested Capital 2 2

12. Components of ROI Total Assets • Perspective is that of its total
financing base
• Called return on assets (ROA)
ROA:
 measures operating efficiency/ performance
 reflects return from all financing
 does not distinguish return by
financing sources 2 2

13. Components of ROI Total Assets
Some adjust this invested capital base for:
1. Unproductive Assets (subtracted)
2. Intangible Assets (subtracted)
3. Accumulated Depreciation (not subtracted) 2 2

14. Components of ROI Total Assets Unproductive Asset Adjustment
• Assumes management not responsible for earning a return on capital not in operations
• Excludes inactive plants, facilities under construction, surplus plants, surplus inventories, surplus cash
Such adjustment is not valid as it fails to:
 recognize that management has discretion over all investment
 assess overall management effectiveness 2 2

15. Components of ROI Total Assets Intangible Asset Adjustment
Excludes intangible assets from invested capital assuming skepticism about their values
Adjustment is not valid as:
 Lack of information or increased uncertainty does not justify exclusion 2 2

16. Components of ROI Total Assets Accumulated Depreciation Adjustment
• Assumes plant assets maintained in prime condition
• Assumes inappropriate to assess return relative to net assets
• Concern with a decreasing invested capital base
Adjustment is not valid as:
 It is inconsistent with computation of income net of depreciation expense
 Acquisitions of new depreciable assets offset a declining capital base
 It fails to recognize increased maintenance costs as assets age 2 2

17. Long-Term Debt Plus Equity Capital
Components of ROI
Long-Term Debt Plus Equity Capital
• Perspective is that of the two main suppliers of long-term financing —long-term creditors and equity shareholders
• Referred to as “Return on long-term capitalization”
• Excludes current liability financing 2 2

18. Components of ROI Common Equity Capital
• Perspective is that of common equity holders
• Captures the effect of leverage (debt) capital on equity holder return (financial leverage)
• Excludes all debt financing and preferred equity 2 2

19. Market Value of Invested Capital
Components of ROI
Market Value of Invested Capital
• Assumes certain assets not recognized in financial statements
• Uses the market value of invested capital (debt and equity) 2 2

20. Investor Invested Capital
Components of ROI
Investor Invested Capital
• Perspective is that of the individual investor
• Focus is on individual shareholder, not the company
• Uses the purchase price of securities as invested capital 2 2

21. Computing Invested Capital
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 2 2

22. Components of ROI Income Defined
• Definition of income (return) depends on definition of invested capital
• Measures of income in computing return on invested capital must reflect all applicable expenses from the perspective of the capital contributors
• Income taxes are valid deductions in computing income for return on invested capital
Examples:
• Return on total assets capital uses income before interest expense and dividends
• Return on long-term debt plus equity capital uses income before interest expense and dividends
• Return on common equity capital uses net income after deductions for interest and preferred dividends 2 2

23. Adjustments to Invested Capital and Income Numbers
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 2 2

24. Components of ROI Return on Assets -- ROA Net income + Interest
expense (1 -
Tax
rate) +
Minority
interest
income
(Beginning
total
assets +
Ending
total
assets) 2 2 2

25. Components of ROI Return on Long-Term Debt plus Equity
[Also called return on long-term capitalization] 2 2

26. Components of ROI Return on Common Equity -- ROCE
Net income - Preferred dividends
Total common shareholders’ equity
[When ROCE is higher than ROA, it often reflects favorable impacts of leverage] 2 2

27. Analyzing Return on Assets--ROA
Disaggregating ROA
Return on assets = Profit margin x Asset turnover
Profit margin: measures profitability relative to sale (RETURN ON SALES)
Asset turnover (utilization): measures effectiveness in generating sales from assets 2 2

28. Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
Profit margin and asset turnover are interdependent A D Y E K L B F M G N X H O I J C P 2 2

29. Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
ROA = 5%
Food Stores
Transportation Service
Wholesale-Nondurables
Auto Dealers
Builders
Wholesale Trade
Building Materials
Paper
Construction
Air Transportation
Chemicals
Tobacco
Petroleum
Metals
Fisheries
Oil & Gas
Health Services
Hotels
Real Estate
Amusements
Agriculture
Museums 2 2

30. Analyzing Return on Assets--ROA Asset Turnover Analysis
• Asset turnover measures the intensity with which companies utilize assets
• Relevant measure is the
amount of sales
generated 2 2

31. Analyzing Return on Assets--ROA Disaggregating Asset turnover
Sales to Cash: Reflects trade-off between liquidity and accumulation of low-return
funds
Sales to Receivables: Reflects trade-off between increased sales and accumulation
of funds in receivables
Sales to Inventories: Reflects trade-off between funds accumulated in inventory and
the potential loss of current and future sales
Sales to Fixed Assets: Reflects trade-off between fixed asset investments having
high break-even points and investments in more
efficient, productive assets with high sales potential
Sales to Other Assets: Reflects trade-off between
assets held for current and future sales and accumulation
of funds in higher risk assets
Sales to Current Liabilities: Reflects a relation between sales and
current trade liabilities 2 2

32. 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 prefered diviends) divided by the beginning-of-period common
equity 2 2

33. Analyzing Return on Common Equity--ROCE
Disaggregating ROCE
ROCE = Adjusted profit margin × Asset turnover × Leverage
• Adjusted profit margin: portion of each sales dollar remaining for common
shareholders after providing for all costs and claims (including preferred
dividends)
• Asset turnover (utilization): measures effectiveness in generating sales from
assets
• Leverage*: measures the proportion of assets financed by common
shareholders
*Also called financial leverage and common leverage. 2 2

34. Analyzing Return on Common Equity--ROCE
Further Disaggregation of Adjusted Profit Margin
Adjusted profit margin = Pre-tax adjusted profit margin x Retention rate
Pre-tax adjusted profit margin: measure of operating
effectiveness
Retention rate: measure of tax-management effectiveness 2 2

35. Analyzing Return on Common Equity--ROCE Further Disaggregation of ROCE
ROCE = [(EBIT profit margin × Asset turnover) – Interest burden] × Leverage × Retention rate
• EBIT is earnings (income) before interest and taxes (and before any preferred dividends)
• EBIT profit margin is EBIT divided by sales
• Interest burden is interest expense divided by average assets
This disaggregation highlights effects of both interest and taxes on ROCE 2 2

36. Analyzing Return on Common Equity--ROCE Assessing Equity Growth
• Assumes earnings retention and a
constant dividend payout
• Assesses common equity growth rate through earnings retention 2 2

37. Analyzing Return on Common Equity--ROCE Assessing Equity Growth
Assumes internal growth
depends on both earnings retention and return earned
on the earnings retained 2 2

38. Analyzing Return on Common Equity--ROA
Leverage and 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 2 2

39. Analyzing Return on Common Equity--ROCE
Analyzing Leverage on Common Equity 2 2

40. Analyzing Return on Common Equity--ROCE
Return on Shareholders’ Investment--ROSI 2 2