8-1

Return on Invested Capital and

Profitability Analysis

CHAPTER

8-2

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA
Disaggregating
Profit Margin

Net Operating
Assets

Stockholders
Equity

Disaggregating
Asset Turnover

Analyzing Return
on Common Equity
-ROCE
Role in Equity
Valuation
ROCE
Disaggregation

Assessing
Equity Growth

8-3

Return on
Invested Capital

Joint
Analysis

8-4

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 on
on invested
invested capital
capital (ROIC)
(ROIC) or
or
Return
Return on
on Investment
Investment (ROI)
(ROI) is
is an
an important
important
joint
joint analysis
analysis

8-5

Return on Invested Capital

ROI Relation
ROI
ROIrelates
relatesincome,
income, or
orother
otherperformance
performance measure,
measure,
to
toaacompanys
companyslevel
leveland
andsource
sourceof
of financing
financing
ROI
ROIallows
allowscomparisons
comparisonswith
withalternative
alternative investment
investment
opportunities
opportunities
Riskier
Riskierinvestments
investmentsexpected
expected to
toyield
yieldaahigher
higherROI
ROI
ROI
ROIimpacts
impactsaacompanys
companysability
ability
to
tosucceed,
succeed, attract
attractfinancing,
financing,
repay
repaycreditors,and
creditors,andreward
rewardowners
owners

8-6

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

8-7

Return on Invested Capital

Application of ROI
ROI is applicable to:
(1)
(2) (2)
(3) (3)
measuring measuring
measuring Measure
measure
for for
managerial profitability
Profitabilityplanning
planning
andand
effectiveness
control
control

8-8

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

8-9

Components of ROI
Return on invested capital is defined as:
Income
Invested Capital

8-10

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

8-11

Components of ROI
Alternative Measures of Invested Capital
Common Measures: ROA vs
ROE ?

Net Operating Assets

Stockholders Equity

8-12

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Net Operating
Assets

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA

8-13

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

RNOA:
RNOA:

measures
measuresoperating
operatingefficiency/
efficiency/
performance
performance

reflects
reflectsreturn
returnon
onnet
net operating
operating
assets
assets(excluding
(excluding financial
financial
assets/liabilities)
assets/liabilities)

8-14

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Net Operating
Assets

Components
Of ROIC

Defined
Invested
Capital

Stockholders
Equity

Analyzing Return
on Assets-ROA

Disaggregating
RNOA

8-15

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 and
and
preferred
preferred equity
equity
net income less preferred dividends
average common equity

8-16

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

8-17

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

8-18

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..............
NOA

Net financing ................ NFO + SE

8-19

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 stockholders equity less preferred
stock

8-20

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Net Operating
Assets

Components
Of ROIC

Defined
Invested
Capital

Stockholders
Equity

Analyzing Return
on Assets-ROA

Disaggregating
RNOA

8-21

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

8-22

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)

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

Effect of Operating Leverage on RNOA

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

8-26

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA
Disaggregating
Profit Margin

Net Operating
Assets

Stockholders
Equity

8-27

Analyzing Return on Assets-ROA

Disaggregating Profit Margin

NOPAT
Operating profit margin (OPM) =
Sales
Pretax PM = Pretax sales PM + Pretax other PM

8-28

Analyzing Return on Assets-ROA

Disaggregating Profit Margin

Gross Profit Margin: Reflects the gross profit as

a percent of sales
Reflects companys ability to increase or maintain
selling price
Declining margins may indicate that competition has
increased or that the companys products have
become less competitive, or both

Selling Expenses
General and Administrative Expenses

8-29

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA
Disaggregating
Profit Margin

Net Operating
Assets

Stockholders
Equity

Disaggregating
Asset Turnover

8-30

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

8-31

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

8-32

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA
Disaggregating
Profit Margin

Net Operating
Assets

Stockholders
Equity

Disaggregating
Asset Turnover

Analyzing Return
on Common Equity
-ROCE
Role in Equity
Valuation

8-33

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

8-34

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA
Disaggregating
Profit Margin

Net Operating
Assets

Stockholders
Equity

Disaggregating
Asset Turnover

Analyzing Return
on Common Equity
-ROCE
Role in Equity
Valuation
ROCE
Disaggregation

8-35

Analyzing Return on Common Equity-ROCE

Alternate View of ROCE Disaggregation

8-36

Analyzing Return on Common Equity-ROCE

Disaggregating ROCE

8-37

Return on
Invested Capital

Joint
Analysis

Importance
& Application
Of ROIC

Components
Of ROIC

Defined
Invested
Capital

Analyzing Return
on Assets-ROA

Disaggregating
RNOA
Disaggregating
Profit Margin

Net Operating
Assets

Stockholders
Equity

Disaggregating
Asset Turnover

Analyzing Return
on Common Equity
-ROCE
Role in Equity
Valuation
ROCE
Disaggregation

Assessing
Equity Growth

8-38

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
constant dividend
dividend
payout
payout
Assesses
Assessescommon
common equity
equity
growth
growthrate
ratethrough
through
earnings
earnings retention
retention

8-39

Analyzing Return on Common Equity-ROCE

Assessing Equity Growth
Sustainable equity growth rate = ROCE (1Payout rate)

Assumes
Assumesinternal
internalgrowth
growth
depends
dependson
on both
bothearnings
earnings
retention
retentionand
andreturn
return earned
earned on
on
the
theearnings
earningsretained
retained

8-40

Question
10th

11st

Page 472
8-1
8-2
8-11
8-12
Page 478
Problem 8-5
Exercise 8-6 (page 474)

Page 488
8-1
8-2
8-11
8-12
Page 494
Problem 8-5
Exercise 8-6 (page 491)