Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 8-2

Return on Invested Capital and

Profitability Analysis

8
CHAPTER
 8-3

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
 8-4

Return on Invested Capital

ROI Relation
••ROI
ROI relates
relatesincome,
income, or
orother
other performance
performancemeasure,
measure,
to
toaacompany’s
company’slevel
level and
andsource
sourceofof financing
financing
••ROI
ROI allows
allowscomparisons
comparisonswith
withalternative
alternativeinvestment
investment
opportunities
opportunities
••Riskier
Riskier investments
investmentsexpected
expectedto
toyield
yieldaahigher
higherROI
ROI
••ROI
ROI impacts
impactsaacompany’s
company’sability
ability
to
tosucceed,
succeed, attract
attract financing,
financing,
repay
repaycreditors,and
creditors,andreward
rewardowners
owners
 8-5

Return on Invested Capital

Application of ROI
ROI is applicable to:

(1) (2) (2) (3) (3)

measuring measuring
measuring Measure
measurefor for
managerial profitability
Profitabilityplanning
planning
andand
effectiveness control
control
 8-6

Return on Invested Capital

Measuring Managerial Effectiveness

•• Management
Management is is
responsible
responsible for
for all
all
company
company activities
activities

•• ROI
ROI is
is aa measure
measure of
of managerial
managerial
effectiveness
effectiveness in
in business
business activities
activities

•• ROI
ROI depends
depends onon the
the skill,
skill, resourcefulness,
resourcefulness,
ingenuity,
ingenuity, and
and motivation
motivation of of management
management
 8-7

Return on Invested Capital

Measuring Profitability

•• ROI
ROI is
is an
an indicator
indicator of
of company
company
profitability
profitability

•• ROI
ROI relates
relates key
key summary
summary
measures:
measures: profits
profits with
with financing
financing

•• ROI
ROI conveys
conveys return
return on
on invested
invested
capital
capital from
from different
different financing
financing perspectives
perspectives
 8-8

Return on Invested Capital

Measuring for Planning and Control

ROI
ROI assists
assists managers
managers with:
with:

•• Planning
Planning
•• Budgeting
Budgeting
•• Coordinating
Coordinating activities
activities
•• Evaluating
Evaluating opportunities
opportunities
•• Control
Control
 8-9

Components of ROI
• Return on invested capital is defined as:

Income
Invested Capital
 8-10

Components of ROI
Invested Capital Defined

• No universal measure
of invested capital

• Different measures of
invested capital reflect
user’s different
perspectives
 8-11

Components of ROI
Alternative Measures of Invested Capital
Common Measures:

• Net Operating Assets

• Stockholders’ Equity
 8-12

Components of ROI
Net Operating Assets
•• Perspective
Perspectiveisisthat
that of
of the
thecompany
company
as
asaawhole
whole
Called return
•• Called return on
on net
net operating
operating
assets
assets (RNOA)
(RNOA)

RNOA:
RNOA:
measures
 measuresoperating
operatingefficiency/
efficiency/
performance
performance
reflects
 reflectsreturn
returnononnet
netoperating
operating
assets
assets(excluding
(excludingfinancial
financial
assets/liabilities)
assets/liabilities)
 8-13

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 onon 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
 8-14

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
 8-15

Components of ROI
Adjustments to Invested Capital and Income Numbers


 Many
Manyaccounting
accountingnumbers
numbersrequire
require
analytical
analytical adjustment—see
adjustment—seepriorprior chapters
chapters

 Some
Somenumbers
numbersnot
not reported
reportedin infinancial
financial
statements
statementsneed
needtotobe
beincluded
included

 Such
Suchadjustments
adjustmentsarearenecessary
necessaryfor for
effective
effectiveanalysis
analysisof
of return
returnon
oninvested
invested
capital
capital
 8-16

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
 8-17

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
 8-18

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
 8-19

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
 8-20

Effect of Operating Leverage on RNOA

OA = operating assets
OLLEV = operating liabilities leverage ratio
(operating liabilities / NOA)
 8-21

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%
 8-22

Profit Margin and Asset Turnover

Relation between NOPAT Margin, NOA Turnover, and
Return on Net Operating Assets
 8-23

Profit Margin and Asset Turnover

Net operating Asset Turnover v/s
Net operating Profit Margin for Selected Industries
 8-24

Analyzing Return on Assets-ROA

 8-25

Analyzing Return on Assets-ROA

Disaggregating Profit Margin

NOPAT
Operating profit margin (OPM) =
Sales

Pretax PM = Pretax sales PM + Pretax other PM

 8-26

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
 8-27

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
 8-28

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
 8-29

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
 8-30

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
 8-31

Analyzing Return on Common Equity-ROCE

Disaggregating ROCE
 8-32

Analyzing Return on Common Equity-ROCE

Leverage and ROCE

•• Leverage
Leverage refers
refers toto the
the extent
extent ofof invested
invested capital
capital
from
from other
other than
thancommon
commonshareholders
shareholders
•• IfIf suppliers
suppliers of
of capital
capital (other
(other than
than common
common
shareholders)
shareholders) receive
receive less
less than
than ROA,
ROA, then
then
common
common shareholders
shareholders benefit;
benefit; the
the reverse
reverse
occurs
occurs whenwhen suppliers
suppliers of of capital
capital receive
receive more
more
than
thanROA ROA
•• The
Thelarger
larger the
thedifference
differencein inreturns
returnsbetween
between
common
commonequity equityand andother
other capital
capitalsuppliers,
suppliers, the
the
more
moresuccessful
successful(or (orunsuccessful)
unsuccessful) isisthe thetrading
trading
on
onthe theequity
equity
 8-33

Analyzing Return on Common Equity-ROCE

Alternate View of ROCE Disaggregation

 8-34

Analyzing Return on Common Equity-ROCE

Assessing Equity Growth

Equity growth rate = Net income  Preferred dividends  Dividend payout

Average common stockholders’ equity

•• Assumes
Assumesearnings
earningsretention
retention
and
and aaconstant
constantdividend
dividend
payout
payout

•• Assesses
Assessescommon
commonequity
equity
growth
growthrate
ratethrough
through
earnings
earnings retention
retention
 8-35

Analyzing Return on Common Equity-ROCE

Assessing Equity Growth

Sustainable equity growth rate = ROCE  (1Payout rate)

Assumes
Assumesinternal
internal growth
growth
depends
dependsonon both
both earnings
earnings
retention
retentionand
andreturn
returnearned
earnedon
on
the
theearnings
earningsretained
retained