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 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 return on equity 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