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Chapter 08 - Return On Invested Capital and Profitability Analysis

Chapter 8

Return On Invested Capital AndProfitability Analysis

REVIEW

Return on invested capital is important in our analysis of financial statements. inancialstatement analysis involves our assessin! both ris" and return. #he prior three chaptersfocused primarily on ris"$ %hereas this chapter e&tends our analysis to return. Return oninvested capital refers to a company's earnin!s relative to both the level and source of

financin!. It is a measure of a company's success in usin! financin! to !enerate profits$and is an e&cellent measure of operatin! performance. #his chapter describes return oninvested capital and its relevance to financial statement analysis. We also e&plainvariations in measurement of return on invested capital and their interpretation. We alsodisa!!re!ate return on invested capital into important components for additional insi!htsinto company performance. #he role of financial levera!e and its importance for returnsanalysis is e&amined. #his chapter demonstrates each of these analysis techni(uesusin! financial statement data.

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O)#*I+E

Importance of Return on Invested Capital

,easurin! ,ana!erial Effectiveness,easurin! Profitability

,easurin! for Plannin! and Control

Components of Return on Invested Capital

-efinin! Invested Capital

Adustments to Invested Capital and Income

Computin! Return on Invested Capital

Analy/in! Return on +et Operatin! Assets

-isa!!re!atin! Return on +et Operatin! AssetsRelation bet%een Profit ,ar!in and Asset #urnover

Profit ,ar!in Analysis

Asset #urnover Analysis

Analy/in! Return on Common E(uity

-isa!!re!atin! Return on Common E(uity

inancial *evera!e and Return on Common E(uity

Assessin! 0ro%th in Common E(uity

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A+A*12I2 O34EC#IVE2

-escribe the usefulness of return measures in financial statement analysis.

E&plain return on invested capital and variations in its computation.

Analy/e return on net operatin! assets and its relevance in our analysis.

-escribe disa!!re!ation of return on net operatin! assets and the importance of itscomponents.

-escribe the relation bet%een profit mar!in and turnover.

Analy/e return on common shareholders' e(uity and its role in our analysis.

-escribe disa!!re!ation of return on common shareholders' e(uity and therelevance of its components.

E&plain financial levera!e and ho% to assess a company's success in tradin! onthe e(uity across financin! sources.

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5)E2#IO+2

6. #he return that is achieved in any one period on the invested capital of a companyconsists of the returns 7and losses reali/ed by its various se!ments and divisions. Inturn$ these returns are made up of the results achieved by individual product lines

and proects. A %ell9mana!ed company e&ercises ri!orous control over the returnsachieved by each of its profit centers$ and it re%ards the mana!ers on the basis ofsuch results. 2pecifically$ %hen evaluatin! ne% investments in assets or proects$mana!ement %ill compute the estimated returns it e&pects to achieve and use theseestimates as a basis for its decision to invest or not.

:. Profit !eneration is the first and foremost purpose of a company. #he effectiveness ofoperatin! performance determines the ability of the company to survive financially$ toattract suppliers of funds$ and to re%ard them ade(uately. Return on invested capitalis the prime measure of company performance. #he analyst uses it as an indicator ofmana!erial effectiveness$ and;or a measure of the company's ability to earn asatisfactory return on investment.

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B. Profit mar!in$ althou!h important$ is only one aspect of the return on invested capital.#he other is asset turnover. Conse(uently$ %hile Company 3's profit mar!in is hi!h$its asset turnover may have been sufficiently depressed so as to dra! do%n theoverall return on invested capital$ leadin! to the shareholder's complaint.

8. #he asset turnover of Company is

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EERCI2E2

E&ercise 896 7

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E&ercise 89: 7=D minutes

a. +OPA# K +et income K 6D$DDD$DDD & 6D K 6$DDD$DDD

b. First alternative:+OPA# K 6$DDD$DDD L @$DDD$DDDQ6D K 6$@DD$DDD

+et income K 6$@DD$DDD 7:$DDD$DDD ? & H69.=DJ K 6$?=D$DDD

Second alternative:+OPA# K 6$DDD$DDD L @$DDD$DDDQ6D K 6$@DD$DDD

+et income K 6$@DD$DDD 7@$DDD$DDD @ & H69.=DJ K 6$

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E&ercise 89< 76? minutes

a. R+OA K : & ? K 6D

b. ROCE K 6D L 6.B8@ & =.= K 6B.8@

c. R+OA 6D.DD*evera!e advanta!e B.8@Return on e(uity 6B.8@

E&ercise 89= 7

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E&ercise 89? 76? minutes

a. R+OA K < & B K :6

b. ROCE K R+OA L *EV & 2pread K :6 L 76.@@B & 8.= K

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E&ercise 89B 76D minutes

6. c:. ai!her profit mar!in and lo%er asset turnover.b. >i!her asset turnover and lo%er profit mar!in.c. >i!her profit mar!in and similar;lo%er asset turnover.d. >i!her asset turnover and similar;lo%er profit mar!in.e. >i!her asset turnover and lo%er;similar profit mar!in.f. >i!her asset turnover and similar;hi!her profit mar!in.

!. >i!her asset turnover and lo%er profit mar!in.

E&ercise 89F 7:D minutes

#he memorandum to Reliable Auto 2ales President %ould include the follo%in!pointsG

3oth Reliable and *e!end Auto 2ales are perpetually investin! 6DD$DDD inautomobile inventory.

*e!end Auto 2ales is able to !enerate more profit than Reliable because it is

turnin! over its inventory 76D cars more often. 2pecifically$ *e!end is turnin!its inventory over 6D times per year %hile Reliable is turnin! its inventory overonly ? times per year. >ence$ !iven the same investment in automobileinventory$ *e!end is t%ice as profitable as Reliable.

Encoura!e Reliable to sacrifice some return on each sale to increase theinventory turnover. 3y sli!htly reducin! price$ relative to that char!ed by*e!end$ Reliable predictably %ill find that overall profitability increases. #hisis because %hile profit per sale declines$ the number of units sold and$therefore$ inventory turnover %ill increase. #hese factors predictably yieldincreased return on assets.

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E&ercise 896D 7:D minutes

Computation of Asset 7PPSE #urnover Hcomputed as 2ales ; PPSE 7netJG+orthernG 6:$DDD ; :D$DDD K D.@D2outhernG @$DDD ; :D$DDD K D.

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PRO3*E,2

Problem 896 7

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Problem 89: 7?D minutesa. Computation of Return on Invested Capital ,easuresG

As a first step$ %e construct the companys income statement.

2ales 7?DD$DDD units U 6D........................................................... ?$DDD$DDD

i&ed costs................................................................................. 6$?DD$DDD

Variable costs 7?DD$DDD units U =......................................... :$DDD$DDD

*abor costs 7:D employees &

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Problem 89< 7

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Problem 89= 7@D minutes

a. 6. R+OA K +OPA# Av!. +OA

+OPA# K H68@$DDD L :$DDD 9 6:D$DDD 9

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Problem 89? 7=D minutes

a. ROCE K H+et income preferred dividendsJ ; stoc"holders e(uityQQend of year in this problem

ROCE 1ear ?G H6= DJ ; 6:? K 66.:

ROCE 1ear FG H

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Problem 89@ 7B? minutes

3ac"!round InformationG Product A Product B

Yr 7 Yr Yr 7 Yr +umber of units sold..................... 6D$DDD B$DDD @DD FDD

2ellin! price per unit...................... @.DD ?.DD ?D.DD ?D.DD)nit cost.......................................... ?.DD =.DD

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Problem 89B 7@D minutes

a.

2P1RE2 ,A+)AC#)RI+0 CO,PA+1Comparative Common92i/e Income 2tatements

1ear Ended -ecember

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Problem 898 7B? minutes

E#A CORPORA#IO+2tatement of Variations in Income and Income Components

1ear @ versus 1ear ?

!tems tendin" to increase net income:Increase in net salesG

+et sales$ 1ear @........................................ 68@$DDD+et sales$ 1ear ?........................................ 6??$DDD

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Problem 898continued

Anal#sis and !nterpretation:

76 E#A has t%o Ybelo% the lineY items99discontinued operations and a chan!e inaccountin! principle. While net income increased by =:.F$ income from

continuin! operations increased by

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Problem 89F 7B? minutes

a. 6.

Inventory9to92ales

-ata communications....................................... 6$8FB;@$8FD K :B.?#ime recordin! devices..................................... :$B:8;=$6DD K @@.?

>ard%are for electronics.................................. :8B;6$8?D K 6?.?>ome se%in! products..................................... ?:@;6$:@? K =6.@Corporate total................................................... ?$=

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CA2E2

Case 896 76:D minutes

a. Computation of Return on Invested Capital ,easuresG

:DD?

76 Return on net operatin! assets HaJ................... B

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Case 896continued

b. Computation of Asset #urnover RatiosG

:DD?

76 Accounts receivable turnover...................................... 6:.:EE#+et Operatin! AssetsOA Operatin! Assets

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Case 89@continued

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Case 89@continued

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Case 89@continued=. Recast inancial 2tatements of 2ears 3usiness 2e!ments

Income 2tatement Credit Others #otal Avera!e 3alance 2heet

Revenue =D8?

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Case 89@continued

?. Althou!h the ROCEs are similar the source of the ROCE is very different. Wal9,arts ROCE comes from business operations and$ in particular$ its ability tocontrol costs of retail operations as evidenced by hi!her profit mar!ins in itsretail business. 2ears$ on the other hand$ derives its ROCE from financial

levera!e$ particularly throu!h its finance subsidiary. #hat means 2ears ismuch more ris"y and$ therefore$ is accorded a lo%er valuation.

157_28235_EA419_2012_1__2_1_Ch_08

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