1. Return on invested capital and profitability analysis
Chapter 3
Return on invested capital and profitability analysis

2. Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis
In joint analysis we assess one measure relative to another.
Return on invested capital refers to a company’s earnings relative to both the level and source of financing. It is a measure of a company’s success in using financing to generate profits.

3. ROI Relation
Analysis of ROI compares a company’s income, or other performance measure, to the company’s level and source of financing
ROI allows comparisons with alternative investment opportunities
Riskier investments expected to yield a higher ROI
ROI determines a company’s ability to succeed, attract financing, repay creditors, and reward owners

4. Return on Invested Capital
Application of ROI
ROI is applicable to:
(1)
measuring
managerial
effectiveness
(2)
measuring
Profitability
(3)
measure for
planning and
control
(2) measuring profitability
(3)
Measure for planning and control

5. 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 and motivation of management.

6. 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

7. Measuring for Planning and Control
ROI assists managers with:
• Planning
• Budgeting
• Coordinating activities
• Evaluating opportunities
• Control

8. Components of ROI Return on invested capital is defined as: Income

9. Invested Capital Defined
No universal measure of invested capital
Different measures of invested capital reflect user’s different perspectives

10. Common Measures: (i) Net Operating Assets (ii)Stockholders’ Equity.

11. Net Operating Assets Perspective is that of the company as a whole
Called return on net operating assets (RNOA)
RNOA:
 measures operating efficiency/ performance
 reflects return on net operating assets (excluding financial assets/liabilities)

12. net income less preferred dividends
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.
net income less preferred dividends
average common equity

13. 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.

14. Components of ROI NOPAT (Beginning NOA + Ending NOA) / 2 Where
Return on Net Operating Assets -- RNOA
NOPAT
(Beginning NOA + Ending NOA) / 2
Where
NOPAT = Operating income x (1- tax rate)
NOA = net operating assets

15. Components of ROI BALANCE SHEET
Operating and non operating activities - Distinction
BALANCE SHEET
Operating 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

16. Components of ROI Net income - Preferred dividends
Return on Common Equity -- ROCE
Net income - Preferred dividends
(Beginning equity + Ending equity) / 2
Where
Equity is stockholder’s equity less preferred stock

17. Analyzing Return on Assets-ROA
Disaggregating RNOA
Return on operating assets =
Operating Profit margin x Operating Asset turnover
Operating Profit margin: measures operating profitability
relative to sales
Operating Asset turnover (utilization): measures effectiveness
in generating sales from operating assets

18. 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)

19. Analyzing Return on Assets-ROA
Disaggregating Profit Margin
Operating profit margin (OPM) =
NOPAT
Sales
Pretax PM = Pretax sales PM + Pretax other PM

20. 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

21. Analysing 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

22. 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
Disaggregation of Asset Turnover