Importance of invested (ROIC) • The company can be analyzed in various ways:- • Revenue • Net income • Asset growth • All above cannot be used individually hence net income must be matched with invested capital Return on invested capital (ROIC) or (ROI)

• It is most used company measure and not only allows companies to compare their success with invested capital but also assess its return relative to capital investment risk • It also compares returns on invested capital to return on alternative investments. • Return on capital invested can be used in several areas of analysis which include:- 1.Measuring managerial effectiveness

• Management of any company irrespective of size depends primarily on the skill,resourcefulness,ingenuity and motivation of its top managers. • Return on capital invested when computed over intervals of a year or longer is a relevant measure of company's managerial effectiveness. 2.Measuring profitability

• ROIC is an important indicator of a company's long term financial strength and utilizes key summary measures from both income statement and balance sheet to access profitability. 3.Measure for planning and control • ROIC aids in planning,budgeting,coordirnating, evaluating and controlling business activities as it assesses returns or losses for company's segments and divisions.

Components of Return on Invested capital • Return on invested capital is computed as:- =Income/Invested capital There is no universal measure of invested capital from which the can be computed but following measures are frequently used:- (a) Net operating assets (b) Common equity capital Computing invested capital for the period • The most common method is adding the beginning and ending year invested capital and dividing by two. • Adjustments to invested capital and income Analysis of return on capital invested uses reported financial statement numbers as a starting point and most of these numbers need analytical adjustment

Computing Return on invested capital

• Consider the following financial statements and balance sheets for Excell Corporation; • EXCELL CORPORATION • Income Statements • For Years Ended December 31, Year 8 and Year 9 • ($ thousands) Year 8 Year 9 • Sales...... 1,636,298 1,782,254 • Cost of goods sold & operating expenses...... 1,473,293 1,598,679 • Operating ...... 163,005 183,575 • Interest expense...... 21,825 20,843 • Pre-tax profit...... 141,180 162,732 • Tax Expense...... 52,237 58,584 • Net Income...... 88,943 104,148 • •

EXCELL CORPORATION

• Balance Sheets • For Years Ended December 31, Year 8 and Year 9 • ($ thousands) Year 8 Year 9 • Assets • Cash ...... 115,397 71,546 • Marketable securities...... 38,008 43,854 • Accounts receivable, net ...... 177,538 182,859 • Inventories ...... 204,362 256,838 • Total current assets ...... 535,305 555,097 • Investments in unconsolidated subsidiaries...... 33,728 62,390 • Marketable securities...... 5,931 56,997 • Property, plant, & equipment, net ...... 1,539,221 1,633,458 • Goodwill ...... 6,550 6,550 • Total long-term assets ...... 1,585,430 1,759,395

• Total assets...... 2,120,735 2,314,492 • • Liabilities • Notes payable ...... 7,850 13,734 • Accounts payable...... 138,662 155,482 • Taxes payable...... 24,370 13,256 • Current maturities of long-term debt...... 30,440 33,822 • Total current liabilities...... 201,322 216,294 • Long-term debt ...... 507,329 473,507 • Pension and OPEB liabilities...... 743,779 852,237 • Total long-term liabilities...... 1,251,108 1,325,744 • Equity • Common stock ...... 413,783 413,783 • Additional paid-in capital...... 19,208 19,208 • Retained earnings...... 436,752 540,901 • Treasury stock ...... (201,438) (201,438) • Total stockholders’ equity...... 668,305 772,454 • Total liabilities and equity...... 2,120,735 2,314,492 •

Return on Net operating Assets(RNOA)

• RNOA is computed as: • =Net operating profits after tax (NOPAT)/Average Net operating assets • Where operating assets and liabilities are those necessary to conduct company's business. • Net FinancialObligation (NFO) is calculated as distinction between operating liabilities and Non- operating assets which can be shown below:- 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* • Financial Liabilities* - includes preferred stock

ANALYZING RETURN ON NET OPERATING ASSETS • Return on invested capital is useful in management evaluation, profitability analysis, planning and control. • The return measure includes components with the potential to contribute to an understanding of company performance hence need for thorough understanding. • The starting point is a look at Return on Net operating assets (RNOA) • RNOA is computed as follows:- • =Net operating profit after tax/average net operating Assets • This can be disaggregated further into meaningful components relative to sales as follows:- • =Net operating profit margin *Net operating Assets Turnover or

• NOPAT/Sales * Sales/Average NOA • Disaggregation of Profit Margin • Operating profit margin (OPM) is defined as:- • =Net operating profit after tax over sales • The operating profit margin is a function of pre-unit selling price of the product or service compared with the per-unit costs of bringing that product or service to market and servicing customer needs after sale. • For analysis purposes,it is useful to disaggregate pretax profit margin (Pm) into its components:- • Pretax PM=Pretax sales PM + Pretax other PM • Pretax other PM=Equity income/sales+Special items/sales • Pretax sales Pm= Gross margin/sales-selling expenses/sales-administration expenses/sales- Research and development/sales Areas of Importance in our analysis of profitability • Gross Profit: This is measured as revenues less cost of sales and is frequently reported as a percentage.The gross profit or gross profit pecentage is a key performance indicator. • Analyzing changes in sales and cost of sales is useful in identifying major drivers of cost profit • Selling expenses:The importance of the relation between selling expenses and revenues varies across industries and companies

• The analysis of selling expensesthe variable and fixed components which can then be usefully analysed relative to revenues • When selling expenses as a percentage of revenue show an increase,then focus should be having resultant same or higher revenues. • General and administrative expenses: Most general and administrative expenses are fixed,largely because these expensesinclude items like salaries and rent.

• There is a tendency for these expenses to increase especially in prosperous times. • Disaggregation of asset turnover:The standard measure of asset turnover in determining is : • Sales/Average net operating assets • Asset turnover measures the intensity with which the company utilize assets and the most relevant measure of asset utilization is sales which are essential to profits. Accounts receivable turnover

• The account receivable turnover rate is defined as follows:- • =sales/average accounts receivable • Receivables are an assets that must be financed at some cost of capital in addition to collection. • An alternative view of accounts receivable is the average collection period which is calculated as follows:-

• =Accounts receivable/average daily sales • This metric reflect how long accounts receivable are outstanding on average.The lower the receivables turnover rate,the higher the average collection period. • Inventory Turnover: The inventory turnover is computed as follows: • =Cost of goods sold/Average inventory

• The ratio uses cost of goods sold (COGS) as the measure of sales volume because the demonitor,inventory,is reported at cost not retail. • The alternative view of the inventory turnover rate is the Average inventory days outstanding and is calculated as follows:- • =Inventory/Average daily cost of goods sold

• The average inventory days outstanding gives us some indication of the length of time that inventories are available for sale. • Long -term operating Asset turnover:This is computed as follows: =Sales/Average long term operating assets • This is more suitable for capital intensive industries such as manufacturing companies which require investment in long term assets. • They also have lower long-term operating assets turnovers than do less capital intensive companies like service busineses.

Accounts Payable turnover

• The current operating assets like inventories are financed in large part by accounts payable which represent interest-free financing.It is calculated as follows: • =Cost of goods sold/average accounts payable • Another metric analogous to accounts payable turnover is the average payable days outstanding and is calculated as follows:

• =Accounts payable/Average daily cost of goods sold • A lower accounts payable turnover rate corresponds to a higher average payable days outstanding. • Net Operating working capital Turnover: This is equal to operating assets less operating current liabilities. Net operating working capital is an asset that must be financed just like any other asset.It is calculated as follow:-

• =Net sales/Average net operating working capital. • Companies generally desire a higher net operating working capital turnover rate than a lower one. Analyzing return on Common Equity (ROCE) • ROCE is defined as net income less preferred dividends divided by average common equity. • Common equity is defined as total shareholders equity less preferred stock which has a fixed claim to the net assets and cash flow of the company just like debt. • The amount of equity in capital structure and thus the amount of equity used in the computation of is therefore a function of the degree to which the company is financed with debt.

Application of Return on Capital invested (ROIC) • ROIC is used to assess the company's efficiency at allocating the capital under its control to achieve profitable investments. • The return is normally used by investors in making investment decisions especially on where to invest their funds. • It is also used by management especially on decision on how to allocate their capital which may include equity and debt capital