Return on Investment [ROI]The ability to measure performance is essential in developing incentives and controlling operations toward the achievement of company goals. Perhaps the most widely used single measure of profitability of an organization is the rate of Return on Investment [ROI]. Related is the return to stockholders, known as the Return on Equity [ROE]”.

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Through this post I am going to discuss return on investment {ROI] in greater detail and show you how to implement it into a real business strategy. Enjoy!

 

What Is Return On Investment [ROI Basic]?

ROI relates net income to invested capital (total assets). It provides a standard for evaluating how efficiently management employs the average dollar invested in a firm’s assets, whether that dollar came from owners or creditors. Furthermore, a better ROI can also translate directly into a higher return on the stockholder’s’ equity.

ROI is calculated as:

ROI = Net profit after taxes / Total assets

 

Case Example-1

Consider the following financial data:

Total assets                 = $100,000
Net profit after taxes   = $  18,000
[This data will be used along this post]

Then:

ROI = Net profit after taxes / Total assets
= $18,000 / $100,000
= 18%

 

The problem with this formula is that it only tells you about how a company did and how well it fared in the industry. Other than that, it has very little value from the standpoint of profit planning.

To turn it into a powerful tool for business strategy, you would need to expand it!. How? Read on…

 

ROI Made Up of DuPont Formula

In the past, managers have tended to focus on the margin earned and have ignored the turnover of assets. It is important to realize that excessive funds tied up in assets can be just as much of a drag on profitability as excessive expenses. The DuPont Corporation was the first major company to recognize the importance of looking at both net profit margin and total asset turnover in assessing the performance of an organization.

The ROI breakdown, known as the DuPont formula, is expressed as a product of these two factors, as shown next.

 

ROI:
= Net profit after taxes / Total assets
= [Net profit after taxes / Sales] × Sales / Total assets
= Net profit margin × Total assets turnover

The DuPont formula combines the income statement and balance sheet into this otherwise static measure of performance. Net profit margin is a measure of profitability or operating efficiency. It is the percentage of profit earned on sales. This percentage shows how many cents attach to each dollar of sales. Total asset turnover, however, measures how well a company manages its assets. It is the number of times by which the investment in assets turn over each year to generate sales.

The breakdown of ROI is based on the thesis that the profitability of a firm is directly related to management’s ability to manage assets efficiently and to control expenses effectively.

 

Case Example-2

Assume the same data as in Example-1. Also assume sales of $200,000.

Then;

ROI
= Net profit after taxes / Total assets
= $18,000 / $200,000
= 18%

Alternatively,

Net profit margin

= Net profit after taxes / Sales
= $18,000 / $100,000
= 9%

Total asset turnover:
= Sales / Total assets
= $200,000 / $100,000
= 2 Times

Therefore,

ROI
= Net Profit margin × Total asset turnover
= 9% × 2 times = 18%

 

The breakdown provides a lot of insights to CFOs on how to improve the profitability of the company and investment strategy [Note that net profit margin and total asset turnover are called hereafter margin and turnover, respectively, for short].

Specifically, it has at least four advantages over the original formula (i.e., net profit after taxes/total assets) for profit planning. They are:

  • Focusing on the breakdown of ROI provides the basis for integrating many of the management concerns that influence a firm’s overall performance. This will help managers gain an advantage in the competitive environment.
  • The importance of turnover as a key to overall return on investment is emphasized in the break- down. In fact, turnover is just as important as profit margin in enhancing overall return.
  • The importance of sales is explicitly recognized, which is not there in the original formula.
  • The breakdown stresses the possibility of trading one off for the other in an attempt to improve a company’s overall performance. The margin and turnover complement each other. In other words, a low turnover can be made up for by a high margin, and vice versa.

 
The breakdown of ROI into its two components shows that a number of combinations of margin and turnover can yield the same rate of return, as shown next:
         Margin     ×    Turnover    = ROI
(1)    9%            ×     2 times     = 18%
(2)    6              ×     3               = 18
(3)    3              ×     6               = 18
(4)    2              ×     9               = 18

 

 

Is There An Optimal ROI?

There is no ROI that is satisfactory for all companies. Manufacturing firms in various industries will have low rates of return. Structure and size of the firm influence the rate considerably. A company with a diversified product line might have only a fair return rate when all products are pooled in the analysis. In such cases, it seems advisable to establish separate objectives for each line as well as for the total company.

Sound and successful operation must point toward the optimum combination of profits, sales, and capital employed. The combination will necessarily vary depending on the nature of the business and the characteristics of the product. An industry with products tailor-made to customer’s specifications will have different margins and turnover ratios, compared with industries that mass produce highly competitive consumer goods. For example, the combination may describe a supermarket operation that inherently works with low margin and high turnover, while the combination may be a jewelry store that typically has a low turnover and high margin.

 

Using ROI for Profit Planning

The breakdown of ROI into margin and turnover gives management insight into planning for profit improvement by revealing where weaknesses exist: margin or turnover, or both. Various actions can be taken to enhance ROI.
Generally, management can employ three alternatives:

  • Improve margin.
  • Improve turnover.
  • Improve both.

How management can achieve this alternatives? Let’s discuss further…

Alternative-1 demonstrates a popular way of improving performance. Margins may be increased by reducing expenses, raising selling prices, or increasing sales faster than expenses. Some of the ways to reduce expenses are:

  • Use less costly inputs of materials.
  • Automate processes as much as possible to increase labor productivity.
  • Bring the discretionary fixed costs under scrutiny, with various programs either curtailed or eliminated.
  • Discretionary fixed costs arise from annual budgeting decisions by management. Examples include advertising, research and development, and management development programs. The cost-benefit analysis is called for in order to justify the budgeted amount of each discretionary program.

A company with pricing power can raise selling prices and retain profitability without losing business. Pricing power is the ability to raise prices even in poor economic times when unit sales volume may be flat and capacity may not be fully utilized. It is also the ability to pass on cost increases to consumers without attracting domestic and import competition, political opposition, regulation, new entrants, or threats of product substitution. The company with pricing power must have a unique economic position. Companies that offer unique, high-quality goods and services (where the service is more important than the cost) have this economic position.

 

Alternative-2 may be achieved by increasing sales while holding the investment in assets relatively constant, or by reducing assets. Some of the strategies to reduce assets are:

  • Dispose of obsolete and redundant inventory. The computer has been extremely helpful in this regard, making perpetual inventory methods more feasible for inventory control.
  • Devise various methods of speeding up the collection of receivables and also evaluate credit terms and policies.
  • See if there are unused fixed assets.
  • Use the converted assets obtained from use of the previous methods to repay outstanding debts or repurchase outstanding issues of stock. You may release them elsewhere to get more profit, which will improve margin as well as turnover.

 
Alternative-3 may be achieved by increasing sales or by any combinations of alternatives 1 and 2.

 

Case Example-4

Assume that management sets a 20 percent ROI as a profit target. It is currently making an 18 percent return on its investment.

ROI:

= Net profit after taxes / Total assets
= [Net profit after taxes / Sales] × [Sales / Total assets]

 

Present situation:
18% = [18,000 / 200,000] × [200,000 / 100,000]

 

The following alternatives are illustrative of the strategies that might be used [Each strategy is independent of the other]:

 

Alternative-1: Increase the margin while holding turnover constant. Pursuing this strategy would involve leaving selling prices as they are and making every effort to increase efficiency so as to reduce expenses. By doing so, expenses might be reduced by $2,000 without affecting sales and investment to yield a 20 percent target ROI, as follows:

20% = [20,000 / 200,000] x [200,000 / 100,000]

 

Alternative-2: Increase turnover by reducing investment in assets while holding net profit and sales constant. Working capital might be reduced or some land might be sold, reducing investment in assets by $10,000without affecting sales and net income to yield the 20 percent target ROI, as follows:

20% = [18,000 / 200,000] × [200,000 / 90,000]

 

Alternative-3: Increase both margin and turnover by disposing of obsolete and redundant inventories or through an active advertising campaign. For example, trimming down $5,000 worthof investment in inventories would also reduce the inventory holding charge by $1,000. This strategy would increase ROI to 20 percent:

20% = [19,000 / 200,000] x [200,000 / 95,000]

 

Excessive investment in assets is just as much of a drag on profitability as excessive expenses. In this case, cutting unnecessary inventories also helps cut down the expenses of carrying those inventories, so that both margin and turnover are improved at the same time. In practice, alternative 3 is much more common than alternative 1 or 2.

 

Relationship between Return on Investment [ROI] and Return On Equity [ROE]

Generally, a better management performance (i.e., a high or above-average ROI) produces a higher return to investors (equity holders). However, even a poorly managed company that suffers froma below-average performance can generate an above-average return on the stockholders’ equity, simply called the return on equity (ROE). This is because borrowed funds can magnify the returns a company’s profits represent to its stockholders.

Another version of the DuPont formula, called The Modified DuPont Formula, reflects this effect. The formula ties together the ROI and the degree of financial leverage (use of borrowed funds). The financial leverage is measured by the equity multiplier, which is the ratio of a company’s total asset base to its equity investment, or, stated another way, the ratio of how many dollars of assets held per dollar of stockholders’ equity. It is calculated by dividing total assets by stockholder’s equity. This measurement gives an indication of how much of a company’s assets are financed by stockholders’ equity and how much with borrowed funds.
The return on equity (ROE) is calculated as:

ROE:

= Net profit after taxes / Stockholder’s equity
= [Net profit after taxes / Total assets] × [Total assets / Stockholder’s equity]
= ROI × Equity multiplier [This is becalled “The Modified DuPont Formula“]

 

ROE measures the returns earned on the owner’s (both preferred and common stockholder’s) investment. The use of the equity multiplier to convert the ROI to the ROE reflects the impact of the leverage (use of debt) on stockholder’s return:

The equity multiplier:
= Total assets / Stockholder’s equity
= 1 / [1 – Debt ratio]

 

Case Example-5

In Example-1, assume stockholders’ equity of $45,000.

Then,

Equity multiplier:

= Total assets / Stockholder’s equity
= $100,000 / $45,000
= 2.22
= 1 / (1-Debt ratio)
= 1 / (1 – 0.55)
= 1 / 0.45
= 2.22

Therefore:

ROE = Net profit after taxes / Stockholder’s equity
= $18,000 / $45,000
= 40%

ROE = ROE × Equity multiplier = 18% × 2.22 = 40%

 

If the company used only equity, the 18 percent ROI would equal ROE. However, 55 percent of the firm’s capital is supplied by creditors ($45,000/$100,000 = 45% is the equity-to-asset ratio; $55,000/$100,000 = 55% is the debt ratio). Since the 18 percent ROI all goes to stockholders, who put up only 45 percent of the capital, the ROE is higher than 18 percent. This example indicates that the company was using leverage (debt) favorably.

 

Case Example-6

To further demonstrate the interrelationship between a firm’s financial structure and the return it generates on the stockholders’ investments, let us compare two firms that generate $300,000 in operating income. Both firms employ $800,000 in total assets, but they have different capital structures. One firm employs no debt, whereas the other uses $400,000 in borrowed funds.
The comparative capital structures are shown as:

 

                                                           A                    B
Total assets                                 $800,000       $800,000
Total liabilities                                 —                400,000
Stockholder’s equity (a)                 800,000         400,000
Total liabilities and                       
stockholders’ equity                      $800,000    $800,000
   
Firm B pays 10 percent interest for borrowed funds. The comparative income statements and ROEs for firms A and B would look like this:

Operating income                          $300,000    $300,000
Interest expense                             —                 (40,000)
Profit before taxes                         $300,000    $260,000
Taxes (30% assumed)                    (90,000)       (78,000)
Net profit after taxes (b)               $210,000     $182,000
ROE [(b)/(a)]                                     26.25%        45.5%

 

The absence of debt allows firm A to register higher profits after taxes. Yet the owners in firm B enjoy a significantly higher return on their investments. This provides an important view of the positive contribution debt can make to a business, but within a certain limit. Too much debt can increase the firm’s financial risk and thus the cost of financing.

If the assets in which the funds are invested are able to earn a return greater than the fixed rate of return required by the creditors, the leverage is positive and the common stockholders benefit. The advantage of this formula is that it enables the company to break its ROE into a profit margin portion (net profit margin), an efficiency-of-asset-utilization portion (total asset turnover), and a use-of-leverage portion (equity multiplier). It shows that the company can raise shareholder return by employing leverage—taking on larger amounts of debt to help finance growth.

Since financial leverage affects net profit margin through the added interest costs, management must look at the various pieces of this ROE equation, within the context of the whole, to earn the highest return for stockholders. CFOs have the task of determining just what combination of asset return and leverage will work best in its competitive environment. Most companies try to keep at least a level equal to what is considered to be ‘‘normal’’ within the industry.