1、Return on Invested Capital, Joint analysis is where one measure isassessed relative to another Return on invested capital (ROI) is an importantjoint analysis,Return on Invested Capital,Importance of Joint Analysis,Return on Invested Capital,ROI Relation,ROI relates income, or other performance measu
2、re, to a companys level and source of financingROI allows comparisons with alternative investment opportunitiesRiskier investments are expected to yield a higher ROIROI impacts a companys abilityto succeed, attract financing,repay creditors,and reward owners,Return on Invested Capital,Application of
3、 ROI,(1) evaluating managerial effective- ness,(2) assessing profitability,(3) earnings forecasting,(4) planning and control,ROI is applicable to:,Return on Invested Capital,Evaluating Managerial Effectiveness, Management is responsible for all company activities ROI is a measure of managerial effec
4、tiveness in business activities ROI depends on the skill, resourcefulness,ingenuity, and motivation of management,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 c
5、apital from different financing perspectives,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 optimisticor pessimistic forecasts ROI aids in evaluating prior foreca
6、st performance,Return on Invested Capital,For Planning and Control,ROI assists managers with: Planning Budgeting Coordinating activities Evaluating opportunities Control,Components of ROI,Definition,Return on invested capital is defined as:,Components of ROI,Invested Capital Defined, No universal me
7、asureof invested capital exists Different measures of invested capital reflect different financiers perspectives,Components of ROI,Alternative Measures of Invested Capital,Five Common Measures: Total Assets Long-Term Debt Plus Equity Equity Market Value of Invested Capital Investor Invested Capital,
8、Components of ROI,Total Assets, Perspective is that of its totalfinancing base Called return on assets (ROA)ROA: measures operating efficiency/ performance reflects return from all financing does not distinguish return by financing sources,Components of ROI,Total Assets,Some adjust this invested cap
9、ital base for:1. Unproductive Assets2. Intangible Assets3. Accumulated Depreciation,Components of ROI,Total Assets,Unproductive Asset Adjustment Assumes management not responsible for earning a return on capital not in operations Excludes idle plant, facilities under construction, surplus plant, sur
10、plus inventories, surplus cash, and deferred charges from invested capitalAdjustment is not valid as it fails to: recognize that management has discretion over all investment assess overall management effectiveness,Components of ROI,Total Assets,Intangible Asset Adjustment Assumes skepticism of inta
11、ngible asset values Excludes intangible assets from invested capitalAdjustment is not valid as: Lack of information or increased uncertainty does not justify exclusion,Components of ROI,Total Assets,Accumulated Depreciation Adjustment Assumes plant assets maintained in prime condition Assumes inappr
12、opriate to assess return relative to net assets Concern with a decreasing invested capital base Includes an addback for accumulated depreciation on depreciable assetsAdjustment is not valid as: ROA analysis focuses on the performance of the entire company It is inconsistent with computation of incom
13、e net of depreciation expense Acquisitions of new depreciable assets offset a declining capital base It fails to recognize increased maintenance costs as assets age,Components of ROI,Long-Term Debt Plus Equity Capital, Perspective is that of the two mainsuppliers of long-term financing long-term cre
14、ditors and equityshareholders Referred to as long-term capitalization Excludes current liability financing,Components of ROI,Equity Capital, Perspective is that of equity holders Captures the effect of leverage (debt) capital on equity holder return Excludes all debt financing and preferred equity,C
15、omponents 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),Components of ROI,Investor Invested Capital, Perspective is that of the individual investor Focus is on individual shareholder,
16、 not the company Uses the purchase price of securities as 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
17、 interim amounts quarterly or monthly,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 taxe
18、s are valid deductions in computing income for return on invested capitalExamples: 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
19、income after deductions for interest and preferred dividends,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 necessa
20、ry for effective analysis of return on invested capital,Components of ROI,Return on Assets - ROA,Components of ROI,Return on Long-Term Debt plus Equity,Also called return on long-term capitalization,Components of ROI,Return on Common Equity - ROCE,Net income - Preferred dividends Total common shareh
21、olders equityWhen ROCE is higher than ROA, it often reflects favorable impacts of leverageROCE is approximated by Basic earnings per shareBook value per share,Analyzing Return on Assets-ROA,Disaggregating ROA,Profit margin: measures profitability relative to sale Asset turnover (utilization): measur
22、es effectiveness in generating sales from assets,Return on assets = Profit margin x Asset turnover,Analyzing Return on Assets-ROA,Relation Between Profit Margin and Asset Turnover,Profit margin and asset turnover are interdependent,A,D,E,G,F,H,I,B,C,Y,K,J,L,N,P,X,M,O,Analyzing Return on Assets-ROA,R
23、elation Between Profit Margin and Asset Turnover,ROA = 5%,Food Stores,Agriculture,Amusements,Health Services,Metals,Petroleum,Air Transportation,Paper,Building Materials,Construction,Chemicals,Fisheries,Tobacco,Oil & Gas,Hotels,Museums,Real Estate,Auto Dealers,Wholesale Trade,Builders,Wholesale-Nond
24、urables,Transportation Service,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,Sales to Cash: Reflects trade-off between liquidity and accumulation of low-return fundsS
25、ales to Receivables: Reflects trade-off between increased sales and accumulation of funds in receivablesSales to Inventories: Reflects trade-off between funds accumulated in inventory and the potential loss of current and future salesSales to Fixed Assets: Reflects trade-off between fixed asset inve
26、stments having high break-even points and investments in more efficient, productive assets with high sales potentialSales to Other Assets: Reflects trade-off between assets held for current and future sales and accumulation of funds in higher risk assetsSales to Current Liabilities: Reflects a relat
27、ion between sales and current trade liabilities,Analyzing Return on Assets-ROA,Disaggregating Asset turnover,Analyzing Return on Common Equity-ROCE,Role in Equity Valuation,where ROCE is equal to net income available to common shareholders (after prefered diviends) divided by the beginning-of-period
28、 common equity,This can be restated in terms of future ROCE:,Analyzing Return on Common Equity-ROCE,Disaggregating ROCE, Adjusted profit margin: portion of each sales dollar remaining for common shareholders after providing for all costs and claims (including preferred dividends) Asset turnover (uti
29、lization): measures effectiveness in generating sales from assets Leverage*: measures the proportion of assets financed by common shareholders*Also called financial leverage and common leverage.,ROCE = Adjusted profit margin Asset turnover Leverage,Adjusted profit margin = Pre-tax adjusted profit ma
30、rgin x Retention rate,Analyzing Return on Common Equity-ROCE,Further Disaggregation of Adjusted Profit Margin,Pre-tax adjusted profit margin: measure of operating effectivenessRetention rate: measure of tax-management effectiveness,ROCE = (EBIT profit margin Asset turnover) Interest burden Leverage
31、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 assetsThis disaggregation highlights effects of both interest and taxes on ROCE,Analyzing Return
32、on Common Equity-ROCE,Further Disaggregation of ROCE,Analyzing Return on Common Equity-ROCE,Assessing Equity Growth, Assumes earnings retention and aconstant dividend payout Assesses common equity growth rate through earnings retention,Analyzing Return on Common Equity-ROCE,Assessing Equity Growth,A
33、ssumes internal growthdepends on both earnings retention and return earned on the earnings retained,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)
34、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,Analyzing Return on Common Equity-ROCE,Analyzing Leverage on Common Equity,Analyzing Return on Common Equity-ROCE,Return on Shareholders Investment-ROSI,Dividends,
