Return on Invested Capital and Profitability Analysis Week 13 Abdullah Al Shukaili

Learning objectives Computing Return on Invested Capital Analyzing Return on Net Operating Asset Analyzing Return on Common Equity

Return on invested capital Financial statement analysis involves assessing both risk and return Return on invested capital refers to a company’s earnings relative to both the level and source of financing. It is a measure of a company’s success in using financing to generate profits

Importance of Return on investment We can analyze company performance in several ways. Revenue, net income, and asset growth There is also another measure for the performance called return on invested capital (ROIC) The relation between income and invested capital, referred to as return on invested capital (ROIC) or return on investment (ROI) ROI is probably the most widely recognized measure of company performance

Importance of Return on investment ROI is the basic profitability ratio. This ratio establishes relationship between net profit (before interest, tax and dividend) and capital employed. It is expressed as a percentage on investment. The term investment here refers to long-term funds invested in business. This investment is called capital employed.

Capital Employed Capital employed = Equity share capital + preference share capital + Reserve and surplus + long term liabilities

ROI Used 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 investments.

ROI It determines a company’s ability to succeed, attract financing, repay creditors, and reward owners. 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.

ROI computation Return on invested capital ( ROI) is computed as:

When ROI is good? ROI measures how efficiently the sources of the business are being used. In other words, it tells what is the earning capacity of the net assets of the business. Higher the ratio the more efficient is the management and utilization of capital employed.

Exercises For Excel Cooperation Required find :- EBIT in year 2008 = 163,005 Total S/H equity in year 2008 = 668,305 Total common stock = 413,783 Long term debt = 507,329 Required find :- Return on investment ( ROI) Return on common equity ( ROCE)

Exercises ROI = ( EBIT / Invested Capital ) * 100 = {163,005 / (668,305 + 507,329 )} * 100 = {163,005 / 1,175,634} * 100 = 13.8 % This means that the company’s efficiency to generate a return from its invested capital is 13.8 %

Return on common equity (ROCE) (ROCE) is defined as :- (Net income - preferred dividends) / average common equity. Common equity is equal to :- Total shareholders’ equity - preferred stock. Preferred stock is excluded from the computation since, from the viewpoint of common shareholders, preferred stock has a fixed claim to the net assets and cash flow of the company, just like debt.