Return on Invested Capital and Profitability Analysis

The Importance and Application of Joint Analysis

• Joint Analysis Definition: Joint analysis refers to a methodology where one financial measure is assessed relative to another to provide a more comprehensive view of performance.
• Return on Invested Capital (ROIC): Also known as Return on Investment ($ROI$), this is considered one of the most critical joint analyses in financial management.
• The ROI Relation:
  • $ROI$ relates income, or other measures of performance, to a company’s specific level and source of financing.
  • It serves as a benchmark for comparisons against alternative investment opportunities.
  • Risk and Return: Riskier investments are expected to yield a higher $ROI$.
  • Organizational Impact: $ROI$ directly influences a company’s ability to succeed, its capacity to attract new financing, its ability to repay creditors, and its ability to reward owners.
• Applications of ROI:
  • Measuring Managerial Effectiveness: Management is held responsible for all company activities. $ROI$ serves as a metric for managerial efficacy across business activities, reflecting the skill, resourcefulness, ingenuity, and motivation of the leadership team.
  • Measuring Profitability: $ROI$ acts as an indicator of profitability by relating key summary measures (profits) with the financing used to generate them. It conveys return perspectives from different financing vantage points.
  • Measure for Planning and Control: Management utilizes $ROI$ to assist with planning, budgeting, coordinating activities, evaluating new opportunities, and maintaining organizational control.

Components and Measurement of ROI

• Fundamental Definition: Return on Invested Capital is defined by the following ratio:
  • $\text{ROI} = \frac{\text{Income}}{\text{Invested Capital}}$
• Defining Invested Capital: There is no universal measure for "invested capital." Different measures reflect the different perspectives of users (e.g., creditors vs. equity holders).
• Alternative Measures of Invested Capital:
  1. Net Operating Assets (NOA): This perspective looks at the company as a whole, focusing on operating efficiency and performance, excluding financial assets and liabilities.
  2. Stockholders’ Equity: This perspective is specific to common equity holders and captures the effect of leverage on their returns.
• Computing Invested Capital:
  • Usually calculated using the average capital available for the period.
  • Arithmetic Formula: $\frac{\text{Beginning Invested Capital} + \text{Ending Invested Capital}}{2}$
  • Increased Accuracy: A more accurate computation involves averaging interim amounts, such as monthly or quarterly figures.
• Analytical Adjustments: Many accounting numbers require adjustment for effective analysis. This includes including numbers not typically reported in financial statements or adjusting existing figures based on analytical necessity.

Return on Net Operating Assets (RNOA)

• RNOA Calculation:
  • $\text{RNOA} = \frac{\text{NOPAT}}{(\text{Beginning NOA} + \text{Ending NOA}) / 2}$
  • NOPAT (Net Operating Profit After Tax): Calculated as $\text{Operating income} \times (1 - \text{tax rate})$.
  • NOA (Net Operating Assets): Calculated as $\text{Operating Assets (OA) - Operating Liabilities (OL)}$.
• Operating and Nonoperating Activities Distinction:
  • Operating: Includes Operating Assets ($OA$) and Operating Liabilities ($OL$). The net is Net Operating Assets ($NOA$).
  • Nonoperating: Includes Financial Liabilities ($FL$) and Financial Assets ($FA$). The net is Net Financial Obligations ($NFO$).
  • Stockholders' Equity (SE): Represents the ownership interest.
  • Net Financing: Found as $\text{NFO} + \text{SE}$.
• The Effect of Operating Leverage:
  • $\text{OLLEV} = \frac{\text{Operating Liabilities}}{\text{Net Operating Assets}}$
  • This leverage ratio impacts the overall $RNOA$.

Disaggregating Return on Net Operating Assets

• First-Level Disaggregation:
  • $\text{Return on Operating Assets} = \text{Operating Profit Margin} \times \text{Operating Asset Turnover}$
  • Operating Profit Margin (OPM): Measures operating profitability relative to sales. Current formula provided: $\text{OPM} = \frac{\text{NOPAT}}{\text{Sales}}$.
  • Operating Asset Turnover: Measures the effectiveness and intensity with which a company generates sales from its operating assets.
• Second-Level Disaggregation of Profit Margin:
  • Pretax Profit Margin: Includes Pretax Sales Profit Margin and Pretax Other Profit Margin.
  • Gross Profit Margin: Calculated as Gross Profit as a percentage of Sales. It reflects the ability to maintain or increase selling prices. Declining margins suggest increased competition or decreased product competitiveness.
  • Operating Expense Categories: Analyzes Selling Expenses and General and Administrative (G&A) Expenses.
• Second-Level Disaggregation of Asset Turnover:
  • Standard Turnover Ratio: $\frac{\text{Sales}}{\text{Average Net Operating Assets}}$
  • Accounts Receivable Turnover: $\frac{\text{Sales}}{\text{Average Accounts Receivable}}$. Accompanying ratio: Average Collection Period.
  • Inventory Turnover: $\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$. Accompanying ratio: Average Inventory Days Outstanding.
  • Long-term Operating Asset Turnover: $\frac{\text{Sales}}{\text{Average Long-term Operating Assets}}$. Reflects the productivity of long-term assets.
  • Accounts Payable Turnover: $\frac{\text{Cost of Goods Sold}}{\text{Average Accounts Payable}}$. Accompanying ratio: Average Payable Days Outstanding.
  • Net Operating Working Capital Turnover: $\frac{\text{Net Sales}}{\text{Average Net Operating Working Capital}}$.

Detailed Ratio Formulas for Turnover Analysis

• $\text{Average Collection Period} = \frac{\text{Accounts Receivable}}{\text{Average Daily Sales}}$
• $\text{Average Inventory Days Outstanding} = \frac{\text{Inventory}}{\text{Average Daily Cost of Goods Sold}}$
• $\text{Average Payable Days Outstanding} = \frac{\text{Accounts Payable}}{\text{Average Daily Cost of Goods Sold}}$

Interdependence of Profit Margin and Asset Turnover

• Relation: Profit margin and asset turnover are interdependent. Profit margin is a function of sales and expenses ($\text{selling price} \times \text{units sold}$), and turnover is also a function of sales ($\text{sales} / \text{assets}$).
• Industry Dynamics: Different industries exhibit different combinations of margin and turnover to achieve a target $RNOA$ (e.g., 10.3%).
  • High Turnover, Low Margin: Retail, Restaurants.
  • Low Turnover, High Margin: Utilities, Communication, Pharmaceutical, Petroleum, Coal and Natural Gas.
  • Moderate Mix: Apparel, Computers, Chemicals, Printing & Publishing, Health Care, Autos & Trucks.

Return on Common Equity (ROCE)

• Definition: Return on equity available specifically to common shareholders after preferred dividends.
• Calculation:
  • $\text{ROCE} = \frac{\text{Net Income - Preferred Dividends}}{(\text{Beginning Equity + Ending Equity}) / 2}$
  • Equity here is Stockholders' Equity minus Preferred Stock.
• Primary Disaggregation formula:
  • $\text{ROCE} = \text{RNOA} + (\text{LEV} \times \text{Spread})$
• Key ROCE Terms and Definitions:
  • Financial Leverage (LEV): $\frac{\text{Average NFO}}{\text{Average Equity}}$.
  • Net Financial Obligations (NFO): Interest-bearing liabilities minus marketable securities and other nonoperating assets ($\text{NOA - Equity}$).
  • Spread: $\text{RNOA} - \text{NFR}$.
  • Net Financial Rate (NFR): $\frac{\text{NFE}}{\text{Average NFO}}$.
  • Net Financial Expense (NFE): Interest expense minus investment returns from nonoperating assets.
• Impact of Leverage: If capital suppliers (other than common shareholders) receive a return lower than the $ROA$, common shareholders benefit. The reverse is true if capital suppliers receive more than the $ROA$. The magnitude of the difference determines the success of "trading on the equity."
• Alternate View of ROCE Disaggregation:
  • $\text{ROCE} = \text{Adjusted Profit Margin} \times \text{Asset Turnover} \times \text{Leverage}$
  • Expanded terms: $\{ \frac{\text{Net Income - Preferred Dividends}}{\text{Sales}} \} \times \{ \frac{\text{Sales}}{\text{Average Assets}} \} \times \{ \frac{\text{Average Assets}}{\text{Average Common Equity}} \}$

Assessing Equity Growth

• Principle: Assumes internal growth depends on earnings retention and the return earned on those retained earnings.
• Assumptions: This analysis assumes a constant dividend payout and that all growth is generated through earnings retention.