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Unformatted text preview: 1 Chapter 8 Return on invested capital and Profitability analysis This chapter focuses on return with an emphasis on profitability. We emphasize return on invested capital and explain variations in its measurement. Special attention is directed at return on net operating assets and on common shareholders' equity. We explore disaggregation of both these return measures and describe their relevance to our analyses. Financial leverage is explained and analyzed using the return measures in this chapter. Importance of return on in- vested capital Analysis of company performance de- mands joint analyses, where we assess one measure relative to another. The relation between income and invested capital, re- ferred to as return on invested capital (ROIC) or return on investment (ROI), is probably the most widely recognized meas- ure of company performance. It allows us to compare companies on their success with invested capital. It 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 investment. 2 Measuring managerial effectiveness Profit generation is the first and foremost purpose of a company. The effectiveness of oper- ating performance determines the ability of the company to survive financially, to attract suppliers of funds, and to reward them adequately. Return on invested capital is the prime measure of com- pany performance. The analyst uses it as an indi- cator of managerial effectiveness, and/or a meas- ure of the company's ability to earn a satisfactory return on investment. Measuring profitability ROI is an indicator of company profitability ROI relates key summary measures: from the income statement (profits) and balance sheet (financing) to asses profitability. ROI conveys return on invested capital from different financing perspectives of different financing contributors (creditors and shareholders). Measure for planning and control ROI assists managers with: Planning Budgeting Coordinating activities Evaluating opportunities Control Components of return on invested capital There is, however, no complete agreement on the computation of either the numerator or denominator in this relation. These differences stem from the di- verse perspectives of financial statements users. This section describes these differences and explains how different computations are relevant to different users or analyses. We begin with a discussion of invested capital, followed by consideration of income. Defining invested capital No universal measure of invested capital exists Different measures of invested capital reflect different financiers perspectives In this section we describe two different measures of invested capital and explain their relevance to different us- ers and interpretationsnet operating assets and stockholders equity....
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- Spring '11