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McGraw-Hill/Irwin Financial Statement Analysis K R Subramanyam John J Wild 8-2 8 CHAPTER Return on Invested Capital and Profitability Analysis 8-3 Return on Invested Capital • Joint analysis is where one measure is assessed relative to another • Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis • Joint analysis is where one measure is assessed relative to another • Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis Importance of Joint Analysis 8-4 Return on Invested Capital ROI Relation • ROI relates income, or other performance measure, to a company’s level and source of financing • ROI allows comparisons with alternative investment opportunities • Riskier investments expected to yield a higher ROI • ROI impacts a company’ s ability to succeed, attract financing, repay creditors,and reward owners • ROI relates income, or other performance measure, to a company’s level and source of financing • ROI allows comparisons with alternative investment opportunities • Riskier investments expected to yield a higher ROI • ROI impacts a company’ s ability to succeed, attract financing, repay creditors,and reward owners 8-5 Return on Invested Capital Application of ROI (2) measuring profitability (3) Measure for planning and control (1) measuring managerial effectiveness (2) measuring Profitability (3) measure for planning and control ROI is applicable to: 8-6 Return on Invested Capital Measuring Managerial Effectiveness • Management is responsible for all company activities • ROI is a measure of managerial effectiveness in business activities • ROI depends on the skill, resourcefulness, ingenuity, and motivation of management • Management is responsible for all company activities • ROI is a measure of managerial effectiveness in business activities • ROI depends on the skill, resourcefulness, ingenuity, and motivation of management 8-7 Return on Invested Capital Measuring Profitability • ROI is an indicator of company profitability • ROI relates key summary measures: profits with financing • ROI conveys return on invested capital from different financing perspectives • ROI is an indicator of company profitability • ROI relates key summary measures: profits with financing • ROI conveys return on invested capital from different financing perspectives 8-8 Return on Invested Capital Measuring for Planning and Control ROI assists managers with: • Planning • Budgeting • Coordinating activities • Evaluating opportunities • Control ROI assists managers with: • Planning • Budgeting • Coordinating activities • Evaluating opportunities • 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 [...]... for effective analysis of return on invested effective analysis of return on invested capital capital 8-16 Components of ROI Return on Net Operating Assets RNOA NOPAT NOPAT (Beginning NOA + Ending NOA) // 2 (Beginning NOA + Ending NOA) 2 Where • NOPAT = Operating income x (1- tax rate) • NOA = net operating assets 8-17 Components of ROI Operating and nonoperating activities - Distinction BALANCE SHEET... 8-31 Analyzing Return on Common Equity-ROCE Disaggregating ROCE 8-32 Analyzing Return on Common Equity-ROCE Leverage and ROCE •• Leverage refers to the extent of invested capital Leverage refers to the extent of invested capital from other than common shareholders from other than common shareholders •• If suppliers of capital (other than common If suppliers of capital (other than common shareholders)... common equity Assesses common equity growth rate through growth rate through earnings retention earnings retention 8-35 Analyzing Return on Common Equity-ROCE Assessing Equity Growth Sustainable equity growth rate = ROCE × (1−Payout rate) Assumes internal growth Assumes internal growth depends on both earnings depends on both earnings retention and return earned on retention and return earned on the... is the trading on the equity on the 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 earnings retention Assumes earnings retention and a constant dividend and a constant dividend... holder (debt) capital on equity holder return return •• Excludes all debt financing and Excludes all debt financing and preferred equity preferred equity net income less preferred dividends average common equity 8-14 Components of ROI Computing Invested Capital • Usually computed using avera ge capital available for the period • Typically add beginning and ending invested capital amounts and divide by 2... reflects return on net operating  reflects return on net operating assets (excluding financial assets (excluding financial assets/liabilities) assets/liabilities) 8-13 Components of ROI Common Equity Capital •• Perspective is that of common Perspective is that of common equity holders equity holders •• Captures the effect of leverage Captures the effect of leverage (debt) capital on equity holder (debt) capital. .. less than ROA, then common shareholders benefit; the reverse common shareholders benefit; the reverse occurs when suppliers of capital receive more occurs when suppliers of capital receive more than ROA than ROA •• The larger the difference in returns between The larger the difference in returns between common equity and other capital suppliers, the common equity and other capital suppliers, the more... 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) 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... are paid, on average – Accompanying ratio: Average payable days outstanding 8-29 Analyzing Return on Assets-ROA Disaggregation of Asset Turnover 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... obligations NFO Stockholders’ equity SE Net operating assets NOA Net financing NFO + SE 8-18 Components of ROI Return on Common Equity ROCE Net income Preferred dividends Net income Preferred dividends (Beginning equity + Ending equity) // 2 (Beginning equity + Ending equity) 2 Where • Equity is stockholder’s equity less preferred stock 8-19 Analyzing Return on Assets-ROA Disaggregating RNOA Return . reserved. McGraw-Hill/Irwin Financial Statement Analysis K R Subramanyam John J Wild 8-2 8 CHAPTER Return on Invested Capital and Profitability Analysis 8-3 Return on Invested Capital • Joint analysis is where one measure is . another • Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis • Joint analysis is where one measure is assessed relative to another • Return on invested capital. profits with financing • ROI conveys return on invested capital from different financing perspectives 8-8 Return on Invested Capital Measuring for Planning and Control ROI assists managers with: •