Return on Invested Capital &

Profitability Analysis

1
 Define Return on Invested Capital:

The relation between income and invested capital referred to as return on invested
capital (ROIC) or return on investment (ROI) is probably the most widely
recognized measure of company performance. It allows us to compare companies
on their success with invested capital. It also allows us to assess a company’s return
relative to its capital investment risk and we can compare the return on invested
capital to returns of alternative investments.
 
•We use return on invested capital in several areas of our analysis including- 1)
managerial effectiveness, 2) level of profitability and 3) planning and control.

2
 Measuring Managerial Effectiveness:

• The level of return on invested capital depends primarily on the skill, resourcefulness,
ingenuity, and motivation of management. Management is responsible for a company’s
business activities. It makes financing, investing and operating decisions. It selects
actions, plans strategies, and executes plans. Return on invested capital especially when
computed over intervals of a year, or longer, is a relevant measure of a company’s
managerial effectiveness.

3
 Measuring Profitability:

• Return on invested capital is an important indicator of a company’s long

term financial strength. It uses key summary measures from both the
income statement (profits) and the balance sheet (financing) to assess
profitability. This profitability measure has several advantages over other
long term measures of financial strength or solvency that rely on only
balance sheet items (such as debt to equity ratio.) It can effectively
convey the return on invested decisions and action plans for the
company.
4
 Measure for planning and control:
•Return on invested capital serves an important role in planning, budgeting, coordinating,
evaluating and controlling business activities. This return is composed of the returns (losses)
achieved by the company’s segments or divisions. These segment returns are also made up of
the returns achieved by individual product lines, projects and other components. A well-
managed company exercises control over returns achieved by each of its profit centers and
rewards its managers on these centers and rewards its managers on these results.

•So,Return on invested capital is useful in management evaluation, profitability analysis

and planning and control.

5
In evaluating investing alternatives, managements assesses performance
relative to expected returns. Out of this assessment Return on net
operating assets­-
•Net operating income after tax
Net operating assets

6
 Net operating assets:

• Many analyst segregate the balance sheet and income statements in to operating and non
operating components and compute a return on net operating assets (RNOA) as the summary
measure of performance. Operating activities are the core activities of the company. They
include all the activities necessary to bring a product or service to market and to service its
customer needs. In the income statement, operating activities typically include sales, cost of
goods sold, and selling and general and administrative expenses. On the balance sheet operating
activities are represented by the assets and liabilities relating to these income statement
accounts such as accounts receivable, inventories, accounts payable and accrued expenses.
•Capital from varying perspectives of different financing contributors (creditors and
shareholders).
7
• Operating assets are comprised of total assets less financial assets such
as investments in marketable securities. Operating liabilities are
comprised of total liabilities less interest-bearing debt. Operating
assets less operating liabilities yields net operating assets (NOA).

8
 Discuss Return on Net operating Assets:
••  
Return on Net operating assets (RNOA) is computed as:

•The denominator of the equations, net operating assets (NOA), is equal to operating assets less
operating liabilities. Operating assets and liabilities are those necessary to conduct the
company’s business and include cash, accounts receivable, inventories, prepaid expenses
deferred tax assets, property, plant and equipment (PPE) and long term investments related to
strategic acquisitions (such as equity method investments, goodwill, and acquired intangible
assets). Netted from these operating assets are current operating liabilities, such as accounts
payable and accrued expenses and long term operating liabilities, such as pensions and other
post retirement liabilities and deferred income tax liabilities. 9
•Non operating assets include investments in marketable securities,
non strategic equity investments and investments in discontinued
operations prior to sale. Non operating liabilities include bonds
and other long term interest bearing liabilities and the noncurrent
portion of capitalized leases. Non financial obligations (NFO) is
equal to non-operating liabilities less non operating assets.
• 

10
• Net operating assets (Non) = Net financial obligations (NFO) + Stock
holder’s equity (SE). Net operating assets (Non) are equal to total assets
less non operating assets such as short-term, long term investments in
marketable securities. Operating liabilities are equal to total liabilities
less non operating liabilities such as notes payable to banks, long term
indebtedness payable within one year, and long term indebtedness.
• Net operating profit after tax (NOPAT) is the after tax profit earned from
net operating assets

11
 Balance sheet
At December 31, year 8 and year (1000s)

Assets Year-8 Year-9

Cash 115397 71546
Marketable Securities 38008 43854
  Accounts receivables net 177538 182859
Inventories 204362 256838
Total Current assets 535305 555097
Investments in Unconsolidated
subsidiaries
33728 62390
Marketable Securities 5931 56997
Property, Plants equipment net 1539221 1633458
Goodwill 6550 6530
Total long term assets 1585430 1759396
Total assets 2120735 2314492
Notes Payable 7850 13734
Accounts Payable 138662 155482
Taxes Payable 24370 13256
Current maturities of long term 30440 33822
debt
Total Current Liabilities 201322 216294
Long term debt 507329 473507
Pension and OPEB liabilities 743779 852237
Total long term liabilities 1251108 1325734
12
 Equity Year-8 Year-9
Common Stock 413783 413783

Additional Paid in Capital 19203 19203

Retained Earnings 436572 540901

Treasury Stock (201438) (201438)

Total Stockholders equity 668305 712454

Total liabilities and equity 2120735 2314492

13
Income Statements
For years Ended December 31, year 8 and year 9 ( ‘000s)

  Year-8 Year-9

Sales 1636298 1782254

Cost goods sold and 1473293 1598679

operating expenses
Operating Profit 1473293 183575

Interest expenses 163005 20843

Pretax Profit 21825 162732

Tax expenses 14180 58584

Net profit 88943 104148

14
Calculating Net operating Assets
Cash Year-8 Year-9
Marketable Securities 115397 71546
Accounts receivables net 177538 182859
Inventories 204362 256834
Investments in Unconsolidated 33728 62390
subsidiaries
Property, Plants equipment net 1539221 1633458
Goodwill 6530 6530
Accounts Payable (138662) (155482)
Taxes Payable (24370) (13256)
Pension and OPEB liabilities (743779) (852237)
Net operating Assets 1169985 1192666
15
Net Financial Obligations
  Year-8 Year-9

Notes Payable 7850 13734

Current maturities of long term 30440 33822
debt

Long term debt 507329 473507

Marketable Securities Current (38008) (43854)

Marketable Securities Non (5931) (56997)

Current

Net financial obligations 501680 420212

16
•NOA = NFO + SHE
•Net operating asset= Net financial obligations + Stock holder’s equity
•year 8 = NOA = 501680 + 668305
= 11, 69, 985
•year 9 = NOA = 420212 + 772454
= 11, 92, 666

17
• 
•Net operating profit after tax:
•Pretax profit C  (1-Tax rate)

•Effective Tax Rate

•NOPAT = year 8 = 141180  (1-37)

• = 102693
• year 9 = 162732  (1-36)
• = 117488

18
••  
Return or Net operating Assets for year 9.

•So Return on net operating assets

19
Define Common Equity capital
• Return on Common equity (ROCE) is defined as net income less
preferred dividend by average common equity. Common equity is
equal to total shareholders equity less preferred stock. Preferred
stock is excluded from the computation since from the view point of
common shareholders, preferred stock has a fixed claim to the net
assets and cash flow of the company just like debt.

20
• Common equity can alternatively be defined as equal to total assets less debt
and preferred stock. The proportion of debt and equity financing of assets is
equal to capital structure decision that each company must make.

21
• 
•Return on common shareholder’s Equity:
•Return on common equity typically excludes from invested capital all
but common shareholder’s equity. The return on common equity is
computed as –

22
•Return on common equity consists of two components – an operating
assets (RNOA), and non operating return (The positive or negative
effects of financial leverage.)

23
• 
•Disaggregating Return on Net Operating Assets.
• 
•Return on Net operating assets (RNOA) is computed as:
•----------------------(i)

•Return on net operating assets

•= Net operating profit margin  Net operating asset turnover.
•

24
•The NOPAT to sales relation is called net operating profit margin (or simply
NOPAT margin) and measures a company’s operating profitability relative to sales.
The sales to net operating assets relation is called the net operating asset turnover or
simply NOA turnover) and measures a company’s effectiveness to in generating
sales from net operating assets. This decomposition highlights the role of these
components both NOPAT margin and NOA turnover., in determining return on net
operating assets (RNOA). NOPAT margin and NOA turnover are useful measures
the require analysis to gain insights into a company’s profitability.

25
 Return on Net operating Assets

Net operating Asset (NOA)

NOPAT margin
turnover

NOPAT Sales Sales Average NOA

Net operating Long term net operating

Sales costs
working capital Assets

Payables assets + Intangibles and Pension Other L-T

Cost of Sales + Selling expenses Cash + Receivables + operating
& other other long term (L-T) and
+ Administrative and other Inventories + other S.T liabilities
accruals operating assets liabilities
expenses operating assets

26
Effect of operating Leverage
• 
Net operating assets (NOA) are reduced by increases in operating liabilities thus
increasing net operating asset turnover. Provided that the increase in operating
liabilities does not affect NOPAT, RNOA is also increased. The operating liability
effect is seen in this alternate decomposition of RNOA.
• ×(1+OLLEV)

27
•Where OA is operating Assets (gross) and OLLEV (Average Operating
liabilities/Average NOA) is the operating liability leverage ratio, since
OLLEV is a positive number, increasing OLLEV increases RNOA.
• 

28
•Exercise-8.1 Page 445 or 473
•FIT corporations return on net operating assets (RNOA) is 10% and its tax
rate is 40%. Its net operating assets ($4 million) are financed entirely by
common shareholders equity. Management is considering its options to
finance an expansion costing $2 million. It expects return on net operating
assets to remain unchanged. There are two alternatives to finance the
expansion.
1. Issue $1 million bonds with 12% coupon and $1 million common stock.
2. Issue $2 million bonds with 12% coupon
29
•Required:
1. Determine net operating income after tax (NOPAT) and net income for each
alternative.
2. Compute return on common shareholders equity for each alternative (use ending
equity
•C. Calculate the assets-to-equity ratio for each alternative.
•D. Compute return on net operating assets and explain how the level of leverage
interacts with it in helping determine which alternative management should pursue.

30
•Solution:
•Net operating assets = $40,00,000+ 20,00,000 = 60,00,000
•First Alternative
• Net operating income after tax (NOPAT) = 60,0,0,000  10% =
$600,000
•Net income = 600,000 – {(10,00,000 .12) (1-.40)} = 600,000-72,0,00
= $528,000

31
• 
•2nd Alternative
•Net operating income after tax = 60,0,0,000  10% = $600,000
•Net income = 600,000 – {(20,0,0,000 .12) (1-.40)} = 600,000-
144,000 = $456,000
•Req (b) Return on Common share holders equity
•First Alternative
•ROCE =
•= 10.56%

32
• 
2nd Alternative
ROCE = = 11.4%
Req (c) Assets to equity Ratio
 
First Alternative:
Assets to Equity = = 1.2
 
2nd Alternative
Assets to Equity = = 1.5
33
• 
•Req (d)
•Return on net operating Assets
•First Alternative:= = 10%
• 
•2nd Alternative = = 10%

•Solve Exercise 8.2

34
• Second: Notice that interest rate is 12% on the debt (bonds). More
importantly the after tax interest rate is 7.2% [12% (1-.40)] which is less
than RNOA. Hence the company earns more on its assets than its pays
for debt on an after-tax-basis. That is it can successfully trade on the
equity-use bond holders funds to earn additional profits. Finally, since
the second alternative uses more debt, as reflected in the assets-to equity
ratio in C, the second alternative is probably preferred. The shareholders
would take on additional risk with the second alternative, but the
expected returns are greater as evidenced from computations in b.
35
••Assessing
  Growth in Common Equity. (Equity Growth Rate)
•We can assess the common equity growth rate of a company through earnings retention. This analysis
emphasizes equity growth without resort to external financing. To asseess, equity growth, we assume
earnings retention and a constant dividend payout overtime. The equity growth rate is computed as:
• 
•Equity growth rate
• 
•The equity growth rate-for year II of Campbell Soap, is computed as-14.9%
•This measure implies that the Cambell Soup can growth 14.9% per year without increasing its current
level of financing and assuming a continuation of current levels of profitability and common stock
dividends.
• 

36
•Sustainable Equity Growth Rate:
•The sustainable equity growth rate or simply sustainable equity growth,
recognizes that internal growth for a company depends on both earnings
retention and the return earned on the earnings retained. Specifically, the
sustainable equity growth rate is computed as-
•Sustainable equity growth rate = ROCE  (1-payout rate)

37
Short notes
• Define Return on invested capital
• Significance of ROI (Return on Invested capital)
• Define net operating assets
• Define common equity
• Define net financial obligations
• Disaggregating Return on Net operating assets (flow Chart)
• Effect of operating leverage
• Significance of equity growth rate
• Define sustainable equity growth rate.
38