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1、Chapter 8Chapter 8Return On Invested Capital AndReturn On Invested Capital AndProfitability AnalysisProfitability AnalysisREVIEWREVIEWReturn on invested capital is important in our analysis of financial statements.FinancialReturn on invested capital is important in our analysis of financial statemen
2、ts.Financialstatement analysis involves our assessing both risk and return.The prior three chaptersstatement analysis involves our assessing both risk and return.The prior three chaptersfocused primarily on risk,whereas this chapter extends our analysis to return.Return onfocused primarily on risk,w
3、hereas this chapter extends our analysis to return.Return oninvested capital refers to a companys earnings relative to both the levelinvested capital refers to a companys earnings relative to both the levelandand sourcesource ofoffinancing.It is a measure of a companys success in using financing to
4、generate profits,financing.It is a measure of a companys success in using financing to generate profits,and is an excellent measure of operating performance.This chapter describes return onand is an excellent measure of operating performance.This chapter describes return oninvestedinvested capitalca
5、pital andand itsits relevancerelevance toto financialfinancial statementstatement analysis.analysis.WeWe alsoalso explainexplainvariations in measurement of return on invested capital and their interpretation.We alsovariations in measurement of return on invested capital and their interpretation.We
6、alsodisaggregate return on invested capital into important components for additional insightsdisaggregate return on invested capital into important components for additional insightsinto company performance.The role of financial leverage and its importance for returnsinto company performance.The rol
7、e of financial leverage and its importance for returnsanalysis is examined.This chapter demonstrates each of these analysis techniques usinganalysis is examined.This chapter demonstrates each of these analysis techniques usingfinancial statement data.financial statement data.OUTLINEOUTLINEImportance
8、 of Return on Invested CapitalImportance of Return on Invested CapitalMeasuring Managerial EffectivenessMeasuring Managerial EffectivenessMeasuring ProfitabilityMeasuring ProfitabilityMeasuring for Planning and ControlMeasuring for Planning and ControlComponents of Return on Invested CapitalComponen
9、ts of Return on Invested CapitalDefining Invested CapitalDefining Invested CapitalAdjustments to Invested Capital and IncomeAdjustments to Invested Capital and IncomeComputing Return on Invested CapitalComputing Return on Invested CapitalAnalyzing Return on Net Operating AssetsAnalyzing Return on Ne
10、t Operating AssetsDisaggregating Return on Net Operating AssetsDisaggregating Return on Net Operating AssetsRelation between Profit Margin and Asset TurnoverRelation between Profit Margin and Asset TurnoverProfit Margin AnalysisProfit Margin AnalysisAsset Turnover AnalysisAsset Turnover AnalysisAnal
11、yzing Return on Common EquityAnalyzing Return on Common EquityDisaggregating Return on Common EquityDisaggregating Return on Common EquityFinancial Leverage and Return on Common EquityFinancial Leverage and Return on Common EquityAssessing Growth in Common EquityAssessing Growth in Common EquityANAL
12、YSIS OBJECTIVESANALYSIS OBJECTIVESDescribe the usefulness of return measures in financial statement analysis.Describe the usefulness of return measures in financial statement analysis.Explain return on invested capital and variations in its computation.Explain return on invested capital and variatio
13、ns in its computation.Analyze return on net operating assets and its relevance in our analysis.Analyze return on net operating assets and its relevance in our analysis.Describe disaggregation of return on net operating assets and the importance of itsDescribe disaggregation of return on net operatin
14、g assets and the importance of ponents.Describe the relation between profit margin and turnover.Describe the relation between profit margin and turnover.Analyze return on common shareholders equity and its role in our analysis.Analyze return on common shareholders equity and its role in our analysis
15、.Describe disaggregation of return on common shareholders equity and theDescribe disaggregation of return on common shareholders equity and therelevance of its components.relevance of its components.Explain financial leverage and how to assess a companys success in trading on theExplain financial le
16、verage and how to assess a companys success in trading on theequity across financing sources.equity across financing sources.QUESTIONSQUESTIONS1.1.TheThe returnreturn thatthat isis achievedachieved inin anyany oneone periodperiod onon thethe investedinvested capitalcapital ofof a a companycompanycon
17、sists of the returns(and losses)realized by its various segments and divisions.Inconsists of the returns(and losses)realized by its various segments and divisions.Inturn,these returns are made up of the results achieved by individual product lines andturn,these returns are made up of the results ach
18、ieved by individual product lines andprojects.projects.A A well-managedwell-managed companycompany exercisesexercises rigorousrigorous controlcontrol overover thethe returnsreturnsachievedachieved byby eacheach ofof itsits profitprofit centers,centers,andand it it rewardsrewards thethe managersmanag
19、ers onon thethe basisbasis ofofsuchsuch results.results.Specifically,Specifically,whenwhen evaluatingevaluating newnew investmentsinvestments inin assetsassets oror projects,projects,management will compute the estimated returns it expects to achieve and use thesemanagement will compute the estimate
20、d returns it expects to achieve and use theseestimates as a basis for its decision to invest or not.estimates as a basis for its decision to invest or not.2.2.Profit generation is the first and foremost purpose of a company.The effectiveness ofProfit generation is the first and foremost purpose of a
21、 company.The effectiveness ofoperating performance determines the ability of the company to survive financially,tooperating performance determines the ability of the company to survive financially,toattract suppliers of funds,and to reward them adequately.Return on invested capitalattract suppliers
22、of funds,and to reward them adequately.Return on invested capitalis the prime measure of company performance.The analyst uses it as an indicator ofis the prime measure of company performance.The analyst uses it as an indicator ofmanagerialmanagerial effectiveness,effectiveness,and/orand/or a a measu
23、remeasure ofof thethe companyscompanys abilityability toto earnearn a asatisfactory return on investment.satisfactory return on investment.3.3.If If thethe investmentinvestment basebase isis defineddefined asas comprisingcomprising netnet operatingoperating assets,assets,thenthen netnetoperating pro
24、fit(e.g.,before interest)after tax(NOPAT)is the relevant income figure tooperating profit(e.g.,before interest)after tax(NOPAT)is the relevant income figure touse.The exclusion of interest from income deductions is due to its being regarded asuse.The exclusion of interest from income deductions is d
25、ue to its being regarded asa payment for the use of money from the suppliers of debt capital(in the same waya payment for the use of money from the suppliers of debt capital(in the same waythat dividends are regarded as a payment to suppliers of equity capital).NOPAT is thethat dividends are regarde
26、d as a payment to suppliers of equity capital).NOPAT is theappropriate amount to measure against net operating assets as both are consideredappropriate amount to measure against net operating assets as both are consideredto be operating.to be operating.4.4.First,First,thethe motivationmotivation for
27、for excludingexcluding nonproductivenonproductive assetsassets fromfrom investedinvested capitalcapital isisbased on thebased on the ideaidea thatthat managementmanagement isis notnot responsibleresponsible forfor earningearning a a returnreturn onon non-non-operatingoperating investedinvested capit
28、al.capital.Second,Second,thethe exclusionexclusion ofof intangibleintangible assetsassets fromfrom thetheinvestment base is often due to skepticism regarding their value or their contributioninvestment base is often due to skepticism regarding their value or their contributiontoto thethe earningearn
29、ing powerpower ofof thethe pany.UnderUnder GAAP,GAAP,intangiblesintangibles areare carriedcarried atat cost.cost.However,if their cost exceeds their future utility,they are written down(or there willHowever,if their cost exceeds their future utility,they are written down(or there willbebe anan uncer
30、taintyuncertainty exceptionexception regardingregarding theirtheir carryingcarrying valuevalue inin thethe auditorsauditors opinion).opinion).TheThe exclusionexclusion ofof intangibleintangible assetsassets fromfrom thethe assetasset basebase mustmust bebe basedbased onon moremoresubstantialsubstant
31、ial evidenceevidence thanthan a a meremere lacklack ofof understandingunderstanding ofof whatwhat thesethese assetsassetsrepresentrepresent oror anan unsupportedunsupported suspicionsuspicion regardingregarding theirtheir value.value.ThisThis impliesimplies thatthatintangible assets should generally
32、 not be excluded from invested capital.intangible assets should generally not be excluded from invested capital.5.5.TheThe basicbasic formulaformula forfor computingcomputing thethe returnreturn onon investmentinvestment isis netnet incomeincome divideddivided bybytotal invested capital.Whenever we
33、modify the definition of the investment base by,total invested capital.Whenever we modify the definition of the investment base by,say,say,omittingomitting certaincertain itemsitems(liabilities,(liabilities,idleidle assets,assets,intangibles,intangibles,etc.)etc.)wewe mustmust alsoalsoadjust the cor
34、responding income figure to make it consistent with the modified assetadjust the corresponding income figure to make it consistent with the modified assetbase.base.6.6.TheThe relationrelation ofof netnet incomeincome toto salessales isis a a measuremeasure ofof operatingoperating performanceperforma
35、nce(profit(profitmargin).margin).TheThe relationrelation ofof salessales toto totaltotal assetsassets isis a a measuremeasure ofof assetasset utilizationutilization ororturnoverturnovera means of determininga means of determining howhow effectivelyeffectively(in(in termsterms ofof salessales generat
36、ion)generation)thetheassets are utilized.Both of these measures,profit margin as well as asset utilization,assets are utilized.Both of these measures,profit margin as well as asset utilization,determinedetermine thethe returnreturn realizedrealized onon a a givengiven investmentinvestment base.base.
37、SalesSales areare anan importantimportantfactor in both of these performance measures.factor in both of these performance measures.7.7.Profit margin,although important,is only one aspect of the return on invested capital.Profit margin,although important,is only one aspect of the return on invested c
38、apital.The other is asset turnover.Consequently,while Company Bs profit margin is high,The other is asset turnover.Consequently,while Company Bs profit margin is high,itsits assetasset turnoverturnover maymay havehave beenbeen sufficientlysufficiently depresseddepressed soso asas toto dragdrag downd
39、own thetheoverall return on invested capital,leading to the shareholders complaint.overall return on invested capital,leading to the shareholders complaint.8.8.The asset turnover of Company X is 3.The profit margin of Company Y is 0.5%.SinceThe asset turnover of Company X is 3.The profit margin of C
40、ompany Y is 0.5%.Sinceboth companies are in the same industry,it is clear that Company X must concentrateboth companies are in the same industry,it is clear that Company X must concentrateon improving its asset turnover.On the other hand,Company Y must concentrate onon improving its asset turnover.O
41、n the other hand,Company Y must concentrate onimprovingimproving itsits profitprofit margin.margin.MoreMore specificspecific strategiesstrategies dependdepend onon thethe productproduct andandindustry.industry.9.9.The sales to total assets(asset turnover)component of the return on invested capitalTh
42、e sales to total assets(asset turnover)component of the return on invested capitalmeasuremeasure reflectsreflects thethe overalloverall raterate ofof assetasset utilization.utilization.It It doesdoes notnot reflectreflect thethe raterate ofofutilization of individual asset categories that enter into
43、 the overall asset turnover.Toutilization of individual asset categories that enter into the overall asset turnover.Tobetter evaluate the reasons for the level of asset turnover or the reasons for changesbetter evaluate the reasons for the level of asset turnover or the reasons for changesin that le
44、vel,it is helpful to compute the rate of individual asset turnovers that makein that level,it is helpful to compute the rate of individual asset turnovers that makeup the overall turnover rate.up the overall turnover rate.10.The10.Theevaluationevaluationofofreturnreturnononinvestedinvestedcapitalcap
45、italinvolvesinvolvesmanymanyfactors.factors.TheTheinclusion/exclusion of extraordinary gains and losses,the use/nonuse of trends,theinclusion/exclusion of extraordinary gains and losses,the use/nonuse of trends,theeffect of acquisitions accounted for as poolings and their chance of recurrence,theeff
46、ect of acquisitions accounted for as poolings and their chance of recurrence,theeffect of discontinued operations,and the possibility of averaging net income are justeffect of discontinued operations,and the possibility of averaging net income are justa few of many such factors.Moreover,the analyst
47、must take into account the effectsa few of many such factors.Moreover,the analyst must take into account the effectsof price-level changes on return calculations.It also is important that the analyst bearof price-level changes on return calculations.It also is important that the analyst bearin mind
48、that return on invested capital is most commonly based on book values fromin mind that return on invested capital is most commonly based on book values fromfinancial statements rather than on market values.And finally,many assets either dofinancial statements rather than on market values.And finally
49、,many assets either donotnot appearappear inin thethe financialfinancial statementsstatements oror areare significantlysignificantly understated.understated.ExamplesExamples ofofsuch assets are intangibles such as patents,trademarks,research and developmentsuch assets are intangibles such as patents
50、,trademarks,research and developmentactivities,advertising and training,and intellectual capital.activities,advertising and training,and intellectual capital.11.The equity growth rate is calculated as follows:11.The equity growth rate is calculated as follows:Net incomeNet income Preferred dividends