Return on Invested Capital and
Profitability Analysis
Semester 1 2020/2021
ART , PAT
Pokok bahasan
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 onon invested
invested capital
capital (ROIC)
(ROIC) oror
Return
Return onon Investment
Investment (ROI)
(ROI) is
is an
an important
important
joint
joint analysis
analysis
Return on Invested Capital
ROI Relation
••ROI
ROIrelates
relatesincome,
income,or
orother
otherperformance
performance measure,
measure,
to
toaacompany’s
company’slevel
leveland
andsource
sourceof
offinancing
financing
••ROI
ROIallows
allowscomparisons
comparisonswith
withalternative
alternativeinvestment
investment
opportunities
opportunities
••Riskier
Riskierinvestments
investmentsexpected
expectedto
toyield
yieldaahigher
higherROI
ROI
••ROI
ROIimpacts
impactsaacompany’s
company’sability
ability
to
tosucceed,
succeed, attract
attractfinancing,
financing,
repay
repaycreditors,and
creditors,and reward
rewardowners
owners
Application of ROI
ROI is applicable to:
(1) (2) (3)
measuring (2) measuring
measuring (3) measure for
managerial profitability
Profitability Measure forplanning and
effectiveness planning and control
control
•• Management •• ROI
ROIisisan
anindicator
Managementisis indicator ROI
ROIassists
assists
responsible of company
responsibleforforall
all of company managers
managerswith:
with:
company activities profitability
profitability
company activities
•ROI •• ROI
ROIrelates
relateskey •Planning
•ROIisisaameasure
measureof of key •Planning
manageria summary
summary •Budgeting
manageria •Budgeting
effectiveness measures:
measures:profits •Coordinating
effectivenessinin profits •Coordinating
business activities with financing
with financing activities
business activities activities
•ROI •• ROI
ROIconveys •Evaluating
•ROIdepends
dependsononthe
the conveys •Evaluating
skill, resourcefulness, return
returnononinvested
invested opportunities
skill, resourcefulness, opportunities
ingenuity, capital from
ingenuity,and
and capital from •Control
•Control
motivation of different
differentfinancing
financing
motivation of
management perspectives
perspectives
management
Components of ROI
Invested Capital Defined
Income • No universal measure of invested
capital
Invested Capital • Different measures of invested
capital reflect user’s different
perspectives
COMPUTING
•Usually computed using average capital Common Measures:
available for the period •Net Operating
•Typically add beginning and ending
invested capital amounts and divide by 2 Assets
•More accurate computation is to average •Stockholders’
interim amounts — quarterly or monthly Equity
Components of ROI
Net Operating Assets
•• Perspective
Perspective is
is that
that of
of the
the company
company as
as aa
whole
whole
Called return
•• Called return onon net
net operating
operating assets
assets
(RNOA)
(RNOA)
RNOA:
RNOA:
measures
measures operating
operating efficiency/
efficiency/
performance
performance
reflects
reflects return
return on
on net
net operating
operating assets
assets
(excluding
(excluding financial
financial assets/liabilities)
assets/liabilities)
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
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.............. Net financing ................ NFO + SE
NOA
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 andand
preferred
preferred equity
equity
net income less preferred dividends
average common equity
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 stockholder’s equity less
preferred stock
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
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)
Analysis of Return on Net Operating Assets
Sales $5,000,000 $10,000,000 $10,000,000
NOPAT $500,000 $500,000 $100,000
NOA $5,000,000 $5,000,000 $1,000,000
NOPAT margin 10% 5% 1%
NOA turnover 1 2 10
Return on net operating assets 10% 10% 10%
Analyzing Return on Assets-ROA
Analyzing Return on Assets-ROA
Disaggregating Profit Margin
NOPAT
Operating profit margin (OPM) =
Sales
Pretax PM = Pretax sales PM + Pretax other PM
Analyzing Return on Assets-ROA
Disaggregating Profit Margin
• 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
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
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
Analyzing Return on Assets-ROA
Disaggregation of Asset Turnover
Accounts receivable turnover = Sales/Average accounts receivable
Average collection period = Accounts receivable/Average daily sales
Inventory turnover = Cost of goods sold/Average inventory
Average inventory days outstanding = Inventory/Average daily cost of goods sold
Long-term operating asset turnover = Sales/Average long-term operating assets
Accounts payable turnover = Cost of goods sold/Average accounts payable
Average payable days outstanding = Accounts payable/Average daily cost of goods sold
Net operating working capital turnover = Net sales/Average net operating working capital
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
Analyzing Return on Common Equity-ROCE
Assessing Equity Growth
Sustainable equity growth rate = ROCE (1Payout rate)
Assumes
Assumesinternal
internal growth
growth
depends
depends onon both
bothearnings
earnings
retention
retention and
and return
return earned
earned on
on
the
theearnings
earningsretained
retained
