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Importance of Return on Capital Invested (ROIC)

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Importance of Return on Capital Invested (ROIC) Importance of Return on capital 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 Return on investment (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 rate of return 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 Profit........................................................................... 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 return on assets 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
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