Return on Invested
Capital
8
CHAPTER
Return on Invested Capital
Importance of Joint Analysis
• Joint analysis is where one measure is
assessed relative to another
• Return on invested capital (ROI) is an important
joint analysis
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, and with same opportunity over time
• Riskier investments are expected to yield a higher
ROI
• ROI impacts a company’s ability to succeed, attract
financing, repay creditors,and reward owners
Return on Invested Capital
Application of ROI
ROI is applicable to:
(1)
evaluating
managerial
effectiveness
(2)
assessing
profitability
(3)
earnings
forecasting
(4)
planning and
control
Return on Invested Capital
Evaluating 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
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
Return on Invested Capital
Assists in Forecasting Earnings
• ROI links past, current, and forecasted earnings with
invested capital
• ROI adds discipline to forecasting
• ROI helps identify
optimistic or pessimistic
forecasts
• ROI aids in evaluating prior forecast performance
Return on Invested Capital
For Planning and Control
ROI assists managers with:
•
•
•
•
•
Planning
Budgeting
Coordinating activities
Evaluating opportunities
Control
Components of ROI
Definition
Return on invested capital is defined as:
Income
Invested capital
Components of ROI
Invested Capital Defined
• No universal measure
of invested capital
exists
• Different measures of
invested capital reflect
different financiers’
perspectives
Components of ROI
Alternative Measures of Invested Capital
Five Common Measures:
• Total Assets
• Long-Term Debt Plus Equity
• Common Equity
• Market Value of Invested Capital (debt and equity)
• Investor Invested Capital
Components of ROI
Total Assets
• Perspective is that of its total
financing base
• Called return on assets (ROA)
ROA:
 measures operating efficiency/ performance
 reflects return from all financing
 does not distinguish return by
financing sources
Components of ROI
Total Assets
Some adjust this invested capital base for:
1. Unproductive Assets (subtracted)
2. Intangible Assets (subtracted)
3. Accumulated Depreciation (not subtracted)
Components of ROI
Total Assets
Unproductive Asset Adjustment
• Assumes management not responsible for
earning a return on capital not in operations
• Excludes inactive plants, facilities under
construction, surplus plants, surplus
inventories, surplus cash
Such adjustment is not valid as it fails to:
 recognize that management has discretion
over all investment
 assess overall management effectiveness
Components of ROI
Total Assets
Intangible Asset Adjustment
Excludes intangible assets from invested capital
assuming skepticism about their values
Adjustment is not valid as:
 Lack of information or increased uncertainty
does not justify exclusion
Components of ROI
Total Assets
Accumulated Depreciation Adjustment
• Assumes plant assets maintained in prime condition
• Assumes inappropriate to assess return relative to net assets
• Concern with a decreasing invested capital base
Adjustment is not valid as:
 It is inconsistent with computation of income net of
depreciation expense
 Acquisitions of new depreciable assets offset a declining
capital base
 It fails to recognize increased maintenance costs as assets
age
Components of ROI
Long-Term Debt Plus Equity Capital
• Perspective is that of the two main
suppliers of long-term financing —longterm creditors and equity shareholders
• Referred to as “Return on long-term
capitalization”
• Excludes current liability financing
Components of ROI
Common Equity Capital
• Perspective is that of common equity
holders
• Captures the effect of leverage (debt)
capital on equity holder return (financial
leverage)
• Excludes all debt financing and preferred
equity
Components of ROI
Market Value of Invested Capital
• Assumes certain assets not
recognized in financial statements
• Uses the market value of invested
capital (debt and equity)
Components of ROI
Investor Invested Capital
• Perspective is that of the individual
investor
• Focus is on individual shareholder, not
the company
• Uses the purchase price of securities as
invested capital
Components of ROI
Computing Invested Capital
• Usually computed using average capital
available for the period
• Typically add beginning and ending invested
capital amounts and divide by 2
• More accurate computation is to average
interim amounts — quarterly or monthly
Components of ROI
Income Defined
• Definition of income (return) depends on definition of invested
capital
• Measures of income in computing return on invested capital must
reflect all applicable expenses from the perspective of the capital
contributors
• Income taxes are valid deductions in computing income for return
on invested capital
Examples:
• Return on total assets capital uses income before interest
expense and dividends
• Return on long-term debt plus equity capital uses income before
interest expense and dividends
• Return on common equity capital uses net income after
deductions for interest and preferred dividends
Components of ROI
Adjustments to Invested Capital and Income Numbers
 Many accounting numbers require analytical
adjustment—see prior chapters
 Some numbers not reported in financial
statements need to be included
 Such adjustments are necessary for effective
analysis of return on invested capital
Components of ROI
Return on Assets -- ROA
Net income + Interest expense (1 -Tax rate) + Minority interest income
(Beginning total assets + Ending total assets)  2
Components of ROI
Return on Long-Term Debt plus Equity
Net income +Interest expense (1-Tax rate)+Minority interest in income
(Average long-term debt+ Average equity)
[Also called return on long-term capitalization]
Components of ROI
Return on Common Equity -- ROCE
Net income - Preferred dividends
Total common shareholders’ equity
[When ROCE is higher than ROA, it often reflects
favorable impacts of leverage]
Analyzing Return on Assets--ROA
Disaggregating ROA
Return on assets = Profit margin x Asset turnover
Income Income Sales


Assets
Sales Assets
Profit margin: measures profitability relative to sale (RETURN ON
SALES)
Asset turnover (utilization): measures effectiveness in generating
sales from assets
Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
Profit margin and asset turnover are interdependent
Relation between Profit Margin, Asset Turnover, and
Return on Assets
Asset turnover
3.75
3.5
3.25
3
2.75
2.5
2.25
2
1.75
1.5
1.25
1
0.75
C 0.5
0.25
0
-2
-1
A
D
Y
E
B
K
L
F
M
G
N
H
X
O
I
J
P
0
1
2
3
4
5
6
7
8
9
Profit margins %
10
11
12
13
14
15
16
Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
Profit Margin, Asset Turnonver, and Return on Assets for Selected
Industries
6
ROA = 5%
5.5
Food Stores
5
Transportation Service
Asset turnover
4.5
Wholesale-Nondurables
Auto Dealers
Builders
Wholesale Trade
4
3.5
3
Building Materials
Paper
Construction
Air Transportation
Chemicals
Tobacco
Petroleum
Metals
Fisheries
Oil & Gas
Health Services
Hotels
2.5
2
1.5
1
Amusements
0.5
Real Estate
Agriculture
Museums
0
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Profit margins %
5.5
6
6.5
7
7.5
8
Analyzing Return on Assets--ROA
Asset Turnover Analysis
• Asset turnover measures the
intensity with which companies utilize
assets
• Relevant measure is the
amount of sales
generated
Analyzing Return on Assets--ROA
Disaggregating Asset turnover
Sales to Cash: Reflects trade-off between liquidity and accumulation of low-return
funds
Sales to Receivables: Reflects trade-off between increased sales and accumulation
of funds in receivables
Sales to Inventories: Reflects trade-off between funds accumulated in inventory and
the potential loss of current and future sales
Sales to Fixed Assets: Reflects trade-off between fixed asset investments having
high break-even points and investments in more
efficient, productive assets with high sales potential
Sales to Other Assets: Reflects trade-off between
assets held for current and future sales and accumulation
of funds in higher risk assets
Sales to Current Liabilities: Reflects a relation between sales and
current trade liabilities
Analyzing Return on Common Equity--ROCE
Role in Equity Valuation
V  BV +
t
t
NI - (k  BV ) NI
- (k  BV )
NI
- (k  BV
)
t + t +2
t+1
t+1 + . . . + t+n
t+n-1 + . . .
(1+ k)
(1+ k)n
(1+ k)2
This can be restated in terms of future ROCE:
V  BV +
t
t
(ROCE - k)BV
(ROCE
- k)BV
(ROCE - k)BV
t +
t+n
t+1
t +2
t+1 + . . . +
t+n-1 + . . .
n
(1+ k)
(1+ k)
(1+ k)2
where ROCE is equal to net income available to common shareholders
(after prefered diviends) divided by the beginning-of-period common
equity
Analyzing Return on Common Equity--ROCE
Disaggregating ROCE
ROCE = Adjusted profit margin × Asset turnover × Leverage
Average
Net income Net income Preferred dividends Preferred dividends
assets

 Sales 
Sales
Average
Average
Average
assets
common equity
common equity
• Adjusted profit margin: portion of each sales dollar remaining for common
shareholders after providing for all costs and claims (including preferred
dividends)
• Asset turnover (utilization): measures effectiveness in generating sales from
assets
• Leverage*: measures the proportion of assets financed by common
shareholders
*Also called financial leverage and common leverage.
Analyzing Return on Common Equity--ROCE
Further Disaggregation of Adjusted Profit Margin
Adjusted profit margin = Pre-tax adjusted profit
margin x Retention rate
Pre-tax earningsNet incomeNet incomePreferred dividends  Preferred dividends  Preferred dividends
Sales
Sales
Pre-tax earningsPreferred dividends
Pre-tax adjusted profit margin: measure of operating
effectiveness
Retention rate: measure of tax-management effectiveness
Analyzing Return on Common Equity--ROCE
Further Disaggregation of ROCE
ROCE = [(EBIT profit margin × Asset turnover) – Interest
burden] × Leverage × Retention rate
• EBIT is earnings (income) before interest and taxes (and
before any preferred dividends)
• EBIT profit margin is EBIT divided by sales
• Interest burden is interest expense divided by average
assets
This disaggregation highlights effects of both interest and
taxes on ROCE
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 and a
constant dividend payout
• Assesses common equity
growth rate through
earnings retention
Analyzing Return on Common Equity--ROCE
Assessing Equity Growth
Sustainable equity growth rate = ROCE  (1-Payout rate)
Assumes internal growth
depends on both earnings
retention and return earned
on the earnings retained
Analyzing Return on Common Equity--ROA
Leverage and ROCE
• Leverage refers to the extent of invested capital
from other than common shareholders
• If suppliers of capital (other than common
shareholders) receive less than ROA, then
common shareholders benefit; the reverse
occurs when suppliers of capital receive more
than ROA
• The larger the difference in returns between
common equity and other capital suppliers, the
more successful (or unsuccessful) is the trading
on the equity
Analyzing Return on Common Equity--ROCE
Analyzing Leverage on Common Equity
Financing Source
Current liabilities
Analyzing Leverage on Common Equity ($ thousands)
Average Funds
Earnings on Funds
Payment to
Accruing to (Detracting
Supplied
Supplied at 5.677%
Financiers
from) Return on Common
Equity
(a)
$
176,677
$ 10,030
$
412
$ 9,618
Long-term debt
353,985
20,096
Deferred taxes
93,962
5,334
Preferred stock
41,538
11,817(b)
8,279
none
5,334
(c)
2,358
2,908
Earnings in excess of return to financiers
Add: Common equity
Totals
(550)
$ 22,681
—
686,640
38,980
$ 1,352,802
$ 76,798
Total return to shareholders
38,980
$ 15,137
$ 61,661
Return on assets
5.677%
Leverage advantage accruing to common equity
3.303
Return on common equity
8.980%
Analyzing Return on Common Equity--ROCE
Return on Shareholders’ Investment--ROSI
Dividends + Market val ue of earnings reinvested
ROSI 
Share price (cost)