Chapter 8
Chapter 8
Chapter 8
McGraw-Hill/Irwin
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8
CHAPTER
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Return on invested capital (ROIC) or Return on Investment (ROI) is an important joint analysis
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ROI impacts a companys ability to succeed, attract financing, repay creditors,and reward owners
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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
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ROI is an indicator of company profitability ROI relates key summary measures: profits with financing
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Components of ROI
Return on invested capital is defined as: Income Invested Capital
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Components of ROI
Invested Capital Defined
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Components of ROI
Alternative Measures of Invested Capital
Common Measures:
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Components of ROI
Net Operating Assets
Perspective is that of the company as a whole Called return on net operating
assets (RNOA)
RNOA: measures operating efficiency/ performance reflects return on net operating assets (excluding financial assets/liabilities)
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Components of ROI
Common Equity Capital Perspective is that of common equity holders Captures the effect of leverage (debt) capital on equity holder return Excludes all debt financing and preferred equity
net income less preferred dividends average common equity
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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
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Components of ROI
Adjustments to Invested Capital and Income Numbers Many accounting numbers require analytical adjustmentsee 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
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Components of ROI
Return on Net Operating Assets -- RNOA
Where NOPAT = Operating income x (1- tax rate) NOA = net operating assets
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Components of ROI
Operating and nonoperating activities - Distinction 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
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Components of ROI
Return on Common Equity -- ROCE
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OA = operating assets OLLEV = operating liabilities leverage ratio (operating liabilities / NOA)
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NOPAT Sales
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Asset turnover measures the intensity with which companies utilize assets
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Inventories turnover: Reflects how many times inventories are collected on average
Accompanying ratio: Average inventory days outstanding
Long-term Operating Asset turnover: Reflects the productivity of long-term operating assets Accounts Payable turnover: Reflects how quickly accounts payable are paid, on average
Accompanying ratio: Average payable days outstanding
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Accounts receivable turnover = Sales/Average accounts receivable Average collection period = Accounts receivable/Average daily sales Inventory turnover = Cost of goods sold/Average inventory Average inventory days outstanding = Inventory/Average daily cost of goods sold Long-term operating asset turnover = Sales/Average long-term operating assets Accounts payable turnover = Cost of goods sold/Average accounts payable Average payable days outstanding = Accounts payable/Average daily cost of goods sold Net operating working capital turnover = Net sales/Average net operating working capital
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where ROCE is equal to net income available to common shareholders (after preferred dividends) divided by the beginning-of-period common equity
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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
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Assumes internal growth depends on both earnings retention and return earned on the earnings retained