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Return on Invested Capital

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Title: Return on Invested Capital


1
Return on Invested Capital
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
3
Return on Invested Capital
ROI Relation
  • ROI relates income, or other performance measure,
    to a companys 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 companys ability to succeed,
    attract financing, repay creditors,and reward
    owners

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
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
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
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
8
Return on Invested Capital
For Planning and Control
ROI assists managers with Planning
Budgeting Coordinating activities
Evaluating opportunities Control
9
Components of ROI
Definition
Return on invested capital is defined as
10
Components of ROI
Invested Capital Defined
No universal measure of invested capital
exists Different measures of invested
capital reflect different financiers
perspectives
11
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
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
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)
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
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
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
17
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
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
19
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)
20
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
21
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
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
23
Components of ROI
Adjustments to Invested Capital and Income Numbers
  • Many accounting numbers require analytical
    adjustmentsee 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

24
Components of ROI
Return on Assets -- ROA

-

income


interest

Minority


rate)
Tax

(1

expense

Interest


income

Net


2


assets)

total

Ending


assets

total

(Beginning
25
Components of ROI
Return on Long-Term Debt plus Equity
Also called return on long-term capitalization
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
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
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
F
B
M
G
N
X
H
O
I
J
C
P
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
Metals
Petroleum
Fisheries
Oil Gas
Health Services
Hotels
Real Estate
Amusements
Agriculture
Museums
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
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
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
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.
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
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

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
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
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
39
Analyzing Return on Common Equity--ROCE
Analyzing Leverage on Common Equity
40
Analyzing Return on Common Equity--ROCE
Return on Shareholders Investment--ROSI
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