Financial
Statement
Analysis
K.R. Subramanyam
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
8-2
Return on Invested Capital and
Profitability Analysis
8
CHAPTER
8-3
Return on Invested Capital
Importance of Joint Analysis
•• Joint
Joint analysis
analysis is
is where
where one
one measure
measure is
is
assessed
assessed relative
relative to
to another
another
•• Return
Return onon invested
invested capital
capital (ROIC)
(ROIC) oror
Return
Return onon Investment
Investment (ROI)
(ROI) is
is an
an important
important
joint
joint analysis
analysis
8-4
Return on Invested Capital
ROI Relation
8-5
Return on Invested Capital
Application of ROI
ROI is applicable to:
(2) (3)
measuring Measure for
profitability planning and
control
8-6
Return on Invested Capital
Measuring Managerial Effectiveness
8-7
Return on Invested Capital
Measuring Profitability
8-8
Return on Invested Capital
Measuring for Planning and Control
ROI
ROI assists
assists managers
managers with:
with:
•• Planning
Planning
•• Budgeting
Budgeting
•• Coordinating
Coordinating activities
activities
•• Evaluating
Evaluating opportunities
opportunities
•• Control
Control
8-9
Components of ROI
8-10
Components of ROI
Net Operating Assets
8-11
Components of ROI
8-12
Components of ROI
8-13
Components of ROI
8-14
Components of ROI
•• Perspective
Perspective is is that
that of
of common
common
equity
equity holders
holders
•• Captures
Captures the
the effect
effect of
of leverage
leverage
(debt)
(debt) capital
capital onon equity
equity holder
holder
return
return
•• Excludes
Excludes all
all debt
debt financing
financing andand
preferred
preferred equity
equity
net income less preferred dividends
average common equity
8-15
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
8-16
Components of ROI
Adjustments to Invested Capital and Income Numbers
Many
Manyaccounting
accountingnumbers
numbersrequire
require
analytical
analytical adjustment—see
adjustment—seeprior
priorchapters
chapters
Some
Somenumbers
numbersnot
notreported
reportedininfinancial
financial
statements
statementsneed
needtotobe
beincluded
included
Such
Suchadjustments
adjustmentsarearenecessary
necessaryfor for
effective
effectiveanalysis
analysisof
ofreturn
returnon
oninvested
invested
capital
capital
8-17
Components of ROI
NOPAT
NOPAT
(Beginning
(Beginning NOA
NOA ++ Ending
Ending NOA)
NOA) // 22
Where
• NOPAT = Operating income x (1- tax rate)
• NOA = net operating assets
8-18
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.............. Net financing ................ NFO + SE
NOA
8-19
Components of ROI
Net
Net income
income -- Preferred
Preferred dividends
dividends
(Beginning
(Beginning equity
equity ++ Ending
Ending equity)
equity) // 22
Where
• Equity is stockholder’s equity less preferred
stock
8-20
Analyzing Return on Assets-ROA
Disaggregating RNOA
NOPAT NOPAT Sales
Avg. NOA Sales Avg. NOA
Operating Profit margin: measures operating profitability
relative to sales
Operating Asset turnover (utilization): measures effectiveness
in generating sales from operating assets
8-21
OA = operating assets
OLLEV = operating liabilities leverage ratio
(operating liabilities / NOA)
8-22
Profit Margin and Asset Turnover
• Profit margin and asset turnover are
interdependent
– Profit margin is a function of sales and operating
expenses
• (selling price x units sold)
– Turnover is also a function of sales
• (sales/assets)
• X Y Z
Analysis of Return on Net Operating Assets
Sales $5,000,000 $10,000,000 $10,000,000
NOPAT $500,000 $500,000 $100,000
NOA $5,000,000 $5,000,000 $1,000,000
NOPAT margin 10% 5% 1%
NOA turnover 1 2 10
Return on net operating assets 10% 10% 10%
8-23
Profit Margin and Asset Turnover
Relation between NOPAT Margin, NOA Turnover, and
Return on Net Operating Assets
8-24
Profit Margin and Asset Turnover
Net operating Asset Turnover v/s
Net operating Profit Margin for Selected Industries
8-25
Analyzing Return on Assets-ROA
8-26
Analyzing Return on Assets-ROA
Disaggregating Profit Margin
NOPAT
Operating profit margin (OPM) =
Sales
Pretax PM = Pretax sales PM + Pretax other PM
8-27
Analyzing Return on Assets-ROA
Disaggregating Profit Margin
8-28
Analyzing Return on Assets-ROA
Disaggregation of Asset Turnover
• Asset turnover measures the
intensity with which companies utilize
assets
• Relevant measure is the amount of sales
generated
Sales
average net operating assets
8-29
Analyzing Return on Assets-ROA
Disaggregation of Asset Turnover
• Accounts Receivable turnover: Reflects how many times
receivables are collected on average.
– Accompanying ratio: Average collection period
• 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
8-30
Analyzing Return on Assets-ROA
Disaggregation of Asset Turnover
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
8-31
Analyzing Return on Common Equity-ROCE
Role in Equity Valuation
This can be restated in terms of future ROCE:
where ROCE is equal to net income available to common shareholders
(after preferred dividends) divided by the beginning-of-period common
equity
8-32
Analyzing Return on Common Equity-ROCE
Disaggregating ROCE
8-33
Analyzing Return on Common Equity-ROCE
Leverage and ROCE
•• Leverage
Leverage refers
refers to
to the
the extent
extent of
of invested
invested capital
capital
from
fromother
otherthan
thancommon
commonshareholders
shareholders
•• IfIf suppliers
suppliers of
of capital
capital (other
(other than
than common
common
shareholders)
shareholders) receive
receive less
less than
than ROA,
ROA, then
then
common
common shareholders
shareholders benefit;
benefit; the
the reverse
reverse
occurs
occurs whenwhen suppliers
suppliers of of capital
capital receive
receive more
more
than
thanROA ROA
•• The
Thelarger
largerthe
thedifference
differencein inreturns
returnsbetween
between
common
commonequity equityandandother
othercapital
capitalsuppliers,
suppliers, the
the
more
moresuccessful
successful(or(orunsuccessful)
unsuccessful)isisthe thetrading
trading
on
onthe theequity
equity
8-34
Analyzing Return on Common Equity-ROCE
Alternate View of ROCE Disaggregation
8-35
Analyzing Return on Common Equity-ROCE
Assessing Equity Growth
Equity growth rate = Net income Preferred dividends Dividend payout
Average common stockholders’ equity
•• Assumes
Assumesearnings
earningsretention
retention
and
andaaconstant
constantdividend
dividend
payout
payout
•• Assesses
Assessescommon
commonequity
equity
growth
growthrate
ratethrough
through
earnings
earnings retention
retention
8-36
Analyzing Return on Common Equity-ROCE
Assessing Equity Growth
Sustainable equity growth rate = ROCE (1 Payout rate)
Assumes
Assumesinternal
internal growth
growth
depends
dependsonon both
bothearnings
earnings
retention
retentionand
andreturn
returnearned
earned on
on
the
theearnings
earningsretained
retained
