Importance of Return on capital invested (ROIC)

1. CORPORATE FINANCIAL REPORT AND ANALYSIS GROUP MEMBERSCHRISTINE RUORO D63/60981/2013STELLA MURIUKI D63/60877/2013BILLY M. MUTHEE D63/60798/2013ERIC NYAGA FESTUS D63/60554/2012PIERRA MAINA D63/60127/2013KIBET KOSKEY D63/79148/2012DENNIS KIMANI D63/61174/2013MOKTI NARAN PATEL D63/73263/2012JULIANA MAKAU D63/60563/2013WACHIRA SAMUEL D63/60078/2013LECTURER: HERRICK ONDIGO 23/04/2013

2. Importance of Return on capital invested (ROIC) • The company can be analyzed in various ways:- • Revenue • Net income • Asset growth • All above cannot be used individually hence net income must be matched with invested capital

3. Return on invested capital (ROIC) or Return on investment (ROI) • It is most used company measure and not only allows companies to compare their success with invested capital but also assess its return relative to capital investment risk • It also compares returns on invested capital to return on alternative investments. • Return on capital invested can be used in several areas of analysis which include:-

4. 1.Measuring managerial effectiveness • Management of any company irrespective of size depends primarily on the skill,resourcefulness,ingenuity and motivation of its top managers. • Return on capital invested when computed over intervals of a year or longer is a relevant measure of company's managerial effectiveness.

5. 2.Measuring profitability • ROIC is an important indicator of a company's long term financial strength and utilizes key summary measures from both income statement and balance sheet to access profitability. 3.Measure for planning and control • ROIC aids in planning,budgeting,coordirnating, evaluating and controlling business activities as it assesses returns or losses for company's segments and divisions.

6. Components of Return on Invested capital • Return on invested capital is computed as:- =Income/Invested capital There is no universal measure of invested capital from which the rate of return can be computed but following measures are frequently used:- • Net operating assets • Common equity capital

7. Computing invested capital for the period • The most common method is adding the beginning and ending year invested capital and dividing by two. • Adjustments to invested capital and income Analysis of return on capital invested uses reported financial statement numbers as a starting point and most of these numbers need analytical adjustment

8. Computing Return on invested capital • Consider the following financial statements and balance sheets for Excell Corporation; • EXCELL CORPORATION • Income Statements • For Years Ended December 31, Year 8 and Year 9 • ($ thousands) Year 8 Year 9 • Sales............................................................................................. 1,636,298 1,782,254 • Cost of goods sold & operating expenses............................ 1,473,2931,598,679 • Operating Profit........................................................................... 163,005 183,575 • Interest expense.......................................................................... 21,825 20,843 • Pre-tax profit............................................................................... 141,180 162,732 • Tax Expense................................................................................. 52,237 58,584 • Net Income.................................................................................. 88,943 104,148

9. EXCELL CORPORATION • Balance Sheets • For Years Ended December 31, Year 8 and Year 9 • ($ thousands) Year 8 Year 9 • Assets • Cash ............................................................................... 115,397 71,546 • Marketable securities...................................................... 38,008 43,854 • Accounts receivable, net ................................................. 177,538 182,859 • Inventories ...................................................................... 204,362 256,838 • Total current assets ........................................................ 535,305 555,097 • Investments in unconsolidated subsidiaries................... 33,728 62,390 • Marketable securities...................................................... 5,931 56,997 • Property, plant, & equipment, net ................................... 1,539,221 1,633,458 • Goodwill .......................................................................... 6,550 6,550 • Total long-term assets .................................................... 1,585,4301,759,395

10. Total assets..................................................................... 2,120,735 2,314,492 • Liabilities • Notes payable ................................................................. 7,850 13,734 • Accounts payable............................................................ 138,662 155,482 • Taxes payable.................................................................. 24,370 13,256 • Current maturities of long-term debt.............................. 30,44033,822 • Total current liabilities.................................................... 201,322 216,294 • Long-term debt ............................................................... 507,329 473,507 • Pension and OPEB liabilities........................................... 743,779 852,237 • Total long-term liabilities................................................ 1,251,108 1,325,744 • Equity • Common stock ................................................................ 413,783 413,783 • Additional paid-in capital............................................... 19,208 19,208 • Retained earnings........................................................... 436,752 540,901 • Treasury stock ................................................................. (201,438) (201,438) • Total stockholders’ equity................................................ 668,305 772,454 • Total liabilities and equity............................................... 2,120,7352,314,492

11. Return on Net operating Assets(RNOA) • RNOA is computed as: • =Net operating profits after tax (NOPAT)/Average Net operating assets • Where operating assets and liabilities are those necessary to conduct company's business. • Net FinancialObligation (NFO) is calculated as distinction between operating liabilities and Non-operating assets which can be shown below:-

12. 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* • Financial Liabilities* - includes preferred stock

13. ANALYZING RETURN ON NET OPERATING ASSETS • Return on invested capital is useful in management evaluation, profitability analysis, planning and control. • The return measure includes components with the potential to contribute to an understanding of company performance hence need for thorough understanding. • The starting point is a look at Return on Net operating assets (RNOA)

14. RNOA is computed as follows:- • =Net operating profit after tax/average net operating Assets • This can be disaggregated further into meaningful components relative to sales as follows:- • =Net operating profit margin *Net operating Assets Turnover or

15. NOPAT/Sales * Sales/Average NOA • Disaggregation of Profit Margin • Operating profit margin (OPM) is defined as:- • =Net operating profit after tax over sales • The operating profit margin is a function of pre-unit selling price of the product or service compared with the per-unit costs of bringing that product or service to market and servicing customer needs after sale.

16. For analysis purposes,it is useful to disaggregate pretax profit margin (Pm) into its components:- • Pretax PM=Pretax sales PM + Pretax other PM • Pretax other PM=Equity income/sales+Special items/sales • Pretax sales Pm= Gross margin/sales-selling expenses/sales-administration expenses/sales-Research and development/sales

17. Areas of Importance in our analysis of profitability • Gross Profit: This is measured as revenues less cost of sales and is frequently reported as a percentage.The gross profit or gross profit pecentage is a key performance indicator. • Analyzing changes in sales and cost of sales is useful in identifying major drivers of cost profit • Selling expenses:The importance of the relation between selling expenses and revenues varies across industries and companies

18. The analysis of selling expensesthe variable and fixed components which can then be usefully analysed relative to revenues • When selling expenses as a percentage of revenue show an increase,then focus should be having resultant same or higher revenues. • General and administrative expenses: Most general and administrative expenses are fixed,largely because these expensesinclude items like salaries and rent.

19. There is a tendency for these expenses to increase especially in prosperous times. • Disaggregation of asset turnover:The standard measure of asset turnover in determining return on assets is : • Sales/Average net operating assets • Asset turnover measures the intensity with which the company utilize assets and the most relevant measure of asset utilization is sales which are essential to profits.

20. Accounts receivable turnover • The account receivable turnover rate is defined as follows:- • =sales/average accounts receivable • Receivables are an assets that must be financed at some cost of capital in addition to collection. • An alternative view of accounts receivable is the average collection period which is calculated as follows:-

21. =Accounts receivable/average daily sales • This metric reflect how long accounts receivable are outstanding on average.The lower the receivables turnover rate,the higher the average collection period. • Inventory Turnover: The inventory turnover is computed as follows: • =Cost of goods sold/Average inventory

22. The ratio uses cost of goods sold (COGS) as the measure of sales volume because the demonitor,inventory,is reported at cost not retail. • The alternative view of the inventory turnover rate is the Average inventory days outstanding and is calculated as follows:- • =Inventory/Average daily cost of goods sold

23. The average inventory days outstanding gives us some indication of the length of time that inventories are available for sale. • Long -term operating Asset turnover:This is computed as follows: =Sales/Average long term operating assets • This is more suitable for capital intensive industries such as manufacturing companies which require investment in long term assets. • They also have lower long-term operating assets turnovers than do less capital intensive companies like service busineses.

24. Accounts Payable turnover • The current operating assets like inventories are financed in large part by accounts payable which represent interest-free financing.It is calculated as follows: • =Cost of goods sold/average accounts payable • Another metric analogous to accounts payable turnover is the average payable days outstanding and is calculated as follows:

25. =Accounts payable/Average daily cost of goods sold • A lower accounts payable turnover rate corresponds to a higher average payable days outstanding. • Net Operating working capital Turnover: This is equal to operating assets less operating current liabilities. Net operating working capital is an asset that must be financed just like any other asset.It is calculated as follow:-

26. =Net sales/Average net operating working capital. • Companies generally desire a higher net operating working capital turnover rate than a lower one.

27. Analyzing return on Common Equity (ROCE) • ROCE is defined as net income less preferred dividends divided by average common equity. • Common equity is defined as total shareholders equity less preferred stock which has a fixed claim to the net assets and cash flow of the company just like debt. • The amount of equity in capital structure and thus the amount of equity used in the computation of return on equity is therefore a function of the degree to which the company is financed with debt.

28. Application of Return on Capital invested (ROIC) • ROIC is used to assess the company's efficiency at allocating the capital under its control to achieve profitable investments. • The return is normally used by investors in making investment decisions especially on where to invest their funds. • It is also used by management especially on decision on how to allocate their capital which may include equity and debt capital