Management Accounting 305 Return on Investment

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1 Management Accounting 305 Return on Investment Profit or net income without question is a primary goal of any business. Any business that fails to be profitable in the long run will not survive or will find itself in bankruptcy. However, the mere existence of profit alone can not guarantee continuity of a business. Profit must be satisfactory from the viewpoint of the investors and, for this reason, profit while a measure of success itself must be evaluated. For example, if company A has net income of $100,000 and company B has net income of $1,000,000, which company is the most successful? It appears Company B might be more successful, however, the size of net income is not the measure of satisfactory. If company A s total assets is $1,000,000 while company B s total assets is $100,000,000, the rate of return respectively for companies A and B is 10% and 1%. Company A is, therefore, more likely to be evaluated favorably. In order to compare companies in terms of profitability, net income must be expressed as a rate of return. To start a business, an entrepreneur must raise capital. The term capital is a somewhat ambiguous term which can either refer to the investment of money or funds in assets (plant and equipment) or to the source of the funds. The use of the term capital tends to have a more narrow meaning in accounting than in finance. In accounting, the term capital refers to the contribution of assets by the owners (either a proprietor, partners, or stockholders.) In finance, the term capital is employed to encompass all sources of funds including both creditors and owners. The terms debt capital and equity capital are commonly employed. The accounting equation is typically expressed: Assets = Liabilities + Capital. In finance terms, the same equation would be Assets = Debt Capital + Equity capital. Regardless of how the equation is expressed, the fact remains that the two primary sources of assets are debt capital and equity capital. In other words, a business looks to both creditors and owners for initial financial support. Both parties, creditors and owners, expect a return of the capital that they have invested in the business. The creditors expect a reward in the form of interest and the

2 306 CHAPTER SIXTEEN Return on Investment amount of return expected periodically is determined by the agreed upon interest rate. The owners also expect a return in the form of net income. While the interest rate is a contractual rate, there is generally no rate of return agreement between contributors of equity capital and the business. The one exception is the issue of preferred stock such as 6% nonparticipating preferred stock. However, equity investors do expect a certain rate of return and, therefore, commonly compute a return on investment percentage wise. Good profit performance can not be measured in absolute dollars, but must be measured on a relative basis in terms of a rate by comparing the return on capital to the amount investment in capital. Return on Investment Formula The return on investment ratio equation in simple terms may be defined as follows: Earnings ROI = Investment It is apparent that there are basically two terms that must be understood: (1) earnings and (2) investment. Both terms are ambiguous and, therefore, both require explanation. As it turns out, both terms have two different meanings. The term earnings is often used in relationship to stock shares issued and outstanding. Earnings per share is a frequently used ratio in financial statement analysis. However, the terms earnings in evaluating the adequacy of profit refers to net income. Earnings may either mean net operating income or net income. The following simple income statement is a format used by many businesses: K. L. Widget Company Income Statement For the Year Ended December 31, 20xx Sales $1,000,000 Expenses Selling $600,000 Administrative 200, ,000 Net operating income $ 200,000 Interest $100,000 Taxes 40, ,000 Net income $ 60,000 This particular format clearly shows two types of earnings: net operating income and net income. The management of a business has a responsibility to see that investors recover the investment they have in the business. Net operating income represents the total return in a given period of time before any distribution is made to investors and other

3 Management Accounting 307 claimants. Creditors have first claim on net operating income. If interest is equal to net operating income, then net income is zero and there is nothing that can be claimed by governments in the form of taxes and the return to equity capital providers would be zero. In the above example, the return to creditors is $100,000 and the share of net operating income to governments (state and federal) is $40,000. The return to equity investors is $60,000. In order to state net income as a rate of return, it is necessary to know how much has been invested in the business. Investors, both owners and creditors, have defined investment in two different ways. Some investors have defined investment as meaning total assets while others define investment to mean total equity. Either definition is acceptable, however, care must be taken to use the right measure of earnings. When investment is defined as total assets, then the correct measure of earnings is net operating income. When investment is defined as total equity, then the correct measure of earnings is net income. Net income is the amount of net operating income remaining exclusively for the equity capital providers. Consequently, in the real world of business and finance, two concepts of return on investment have emerged: (1) return on investment-assets and (2) return on investment - equity. Mathematically, we have: Net operating income ROIa = (1) Total assets Net income ROIe = (2) Total equity Net operating income is frequently defined as follows: NOI = Net income + taxes + interest (3) Net operating income is Revenue less all expenses except taxes and interest. It is rather obvious that net operating income can be computed by simply starting with net income and adding back taxes and interest. This can be demonstrated by using the data from the above income statement. Net operating income = $1,000,000 - $800,000 = $200,000 or Net operating income = $60,000 + $100,000 + $40,000 = $200,000 The concept of return on investment-assets should be used when the objective is to evaluate management s performance for the whole business. Management has a responsibility to provide a return on all of the assets intrusted in its care regardless of their source. In one sense, management s first responsibility is to see that net operating income is sufficient to pay the creditors the interest contractually owed. If net income is not adequate for this purpose, then the creditors could force the company into bankruptcy and eventual failure. When net operating income is sufficient for this purpose, then management must consciously strive to make net operating income sufficient to provide the equity investors the rate of return they also expect. If the

4 308 CHAPTER SIXTEEN Return on Investment rate of return to owners is inadequate, then the investors can punish management by causing the value to the stock to decline. In many cases, the owners of stock also serve on the board of directors and can cause management to be replaced for an inadequate return. At all times, in order for the business to survive or for the current management to survive, a conscientious effort must be made to earn an adequate rate of return however measured. The concept of return on investment-equity is a measure more likely to be used by the equity investors rather than management. Net income is the residual after creditors have received their share of net operating income and after the government has been paid its claim again profit. To a large extent, it makes sense for equity investors to regard investment as being total equity. However, when such defined, the correct measure earnings is net income. However, as will be explained in the next section, using ROIe has a fundamental weakness in that management can use the principle of leverage to artificially inflate ROIe. A refinement to the definition of return on investment is to use average investment. The average investment, whether total assets or total equity, is to use the average of the beginning and ending balances. Return on Investment and Leverage The use of ROIe to evaluate whether net income is satisfactory has an inherent weakness in that by increasing debt relative to equity management can increase the return even though net income has in fact decreased. The concept of using debt to leverage the rate of return is a well known technique. To illustrate how the principle of leveraging works, assume the following: Balance Sheet December 31, 20xx Income Statement For the year ended, 20xx Current asset $ 4,000 Sales $ 10,000 Fixed assets 6,000 Cost of goods sold 7,000 $ 10,000 Gross profit $ 3,000 Expenses Liabilities $ 2,000 Operating $ 700 Interest 200 Capital 8,000 Taxes 100 $ 10,000 $ 1,000 Net income $ 2,000 Interest rate = 10% Using both equations for ROI we get: 2,300 ROIa = = 23% ROIe = 2,000 = 25% 10,000 8,000

5 Management Accounting 309 It is apparent that ROIe is larger than ROIa. Now suppose management decides to replace $3,000 of equity with debt. In this event, total liabilities would be $5,000 and total capital would be $5,000. With a debt of $5,000 at 10% interest rate, total interest becomes $500 and net income becomes $1,700. Based on these numbers, ROI becomes: 2,300 1,700 ROIa = = 23% ROIe = = 34% 10,000 5,000 Even though net income decreased by $300, the rate of return on equity increased substantially from 23% to 34%. The problem with this strategy is that the risk of bankruptcy increases as the amount of debt increases relative to equity. Clearly this strategy increases the return to the remaining equity holders but this strategy also puts the business at greater risk. Notice that the ROIa did not change. It remained at 23%. The use of ROIa to evaluate the adequacy of net income reduces the temptation to incur debt for the single purpose of increasing the rate of return. The principle of leverage does not always work. In order for the principle to increase ROI, the necessary condition is that the rate of return on assets must be greater than the interest rate. If not, then the principle will have the opposite effect. The return on investment-equity will be less. In the above example, the interest rate was 10%, but the return on assets was 23%. In this instance, the principle of leverage can be applied effectively. Return on Investment and the dupont Approach There is another approach to ROI analysis that was made popular in the 1940s by the dupont company. This approach introduced into ROI analysis two factors considered important at that time: (1) Profit margin percentage and Investment turnover. This modified ROI equation can be stated as follows: Earnings Sales ROI = x Sales Investment Apparently, many companies at that time regarded a company or a division of a company superior if the gross margin percentage was higher than any of its competitors or internally the division in a company that had a higher gross margin percentage was superior. This reasoning was basically fallacious and the dupont ROI formula was a good way to point this out. Profit margin percentage alone is not an indicator of satisfactory profit performance. Another important factor is investment turnover. A company with a higher profit margin percentage could very well have a much lower ratio of sales to investment. A high level of investment relative to a lower amount of sales will reduce ROI. For example, assume that two companies, A and B are being evaluated for good management in terms of gross profit percentage. The rate of return for both companies has been computed as follows:

6 310 CHAPTER SIXTEEN Return on Investment Company A 300,000 1,000,000 ROI = x = 30% x 2 = 60% 1,000, ,000 Company B 200,000 1,000,000 ROI = x = 20% x 4 = 80% 1,000, ,000 Based on profit margin percentage, company A appears to be the better company; however, this is misleading because company B, in fact, has the higher rate of return (60% vs 80%). Company B has a higher investment turnover rate because of less investment in assets. It is well recognized among those professionals that analyze financial statements that different industries have different profit margin percentages. A furniture store would have a high gross margin percentage but a much lower investment turnover than many other companies in different industries. Using profit margin percentage or investment turnover alone to evaluate profit is not a good idea. Some typical gross margin percentages of different industries are the following: Supermarkets 1.0% Furniture stores 2.5% Discount stores 2.0% Gasoline stations 4.5% Petroleum refining 7.0% If ROIa is the means of evaluating profit, then the ROI formula can be stated as follows: Net operating income Sales ROIa = x Sales Total Assets Using the numbers above in the discussion on leverage we have: 2,000 10,000 ROIa = x =.2 x 1 = 20% 10,000 10,000 The dupont formula reveals two important weaknesses of relying on profit margin percentage as the sole criterion of evaluating net income. The first weakness is the failure to consider the amount of investment in the business and the second weakness is the failure to consider the impact of volume (sales) on the rate of return. The use of this approach does not change the ROI answer. Rather it breaks the rate down into two major components that many believe are important factors in evaluating net income. Return on Investment Weaknesses While ROI formulas of the type discussed so far are useful, they do have a recognized weakness. The return on investment equation is also often used to evaluate future business opportunities. To do this it is necessary to project net income into the future for the estimated life of the projects. Assume that two business projects are

7 Management Accounting 311 being evaluated and that each opportunity as a useful life of 5 years. The cost of each project is $40,000. Net income for each project has been estimated as follows: Proposed Project Net income Total Project A $10,000 $10,000 $10,000 $10,000 $10,000 $50,000 Project B $20,000 $15,000 $10,000 $ 2,500 $ 2,500 $50,000 Both projects have the same total net income and the same average net income per year of $10,000. The annual average rate of return for both projects is 25% (10,000/40,000). But the question is: are both projects in fact equal in terms of profitability? Project A has the same net income each year but project B has more net income in years 1 and 2 and less in years 4 and 5. If net income is the same as net cash flow (this would be the case if there is, for example, no depreciation), then project B is the better project. The reason is that if the present value of each project is computed, then project B has a larger present value and, consequently, a higher time adjusted rate of return. The time adjusted rate of return method is presented in chapter 12. The average rate of return method ignores the difference in the timing of net income. For this reason, many theorists argue that using present value methods is the better approach to evaluating profitability. Planning and Control Approach to Return on Investment Formal profit planning (comprehensive business budgeting) results in a set of planned financial statements and, as a consequence, also results in a planned return on investment. After the budget is completed, the planned rate of return can be computed by dividing planned net operating income by planned total assets. However, a more insightful and analytical approach is to consider the following: Previously net income was defined as: I = P(Q) - ) - F In addition, total assets maybe defined as working capital and fixed capital. Working capital tends to vary directly with volume and, therefore, maybe defined as follows: WC = C(Q) where C is the rate of increase in working capital per dollar change in sales volume. Total assets therefore may be defined as: TA = C(Q) + FC where FC represents total investment in fixed capital. Given the equation for ROI as ROI = E/I, we now have the following equation: P(Q) - V(Q) - F ROI = C(Q ) + FC

8 312 CHAPTER SIXTEEN Return on Investment From this equation, we can see that there are six primary variables that determine return on investment: 1. Price 2. Volume (quantity) 3. Variable cost rate 4. Fixed expenses 5. Working capital rate 6. Total fixed capital. To illustrate, the use of this ROI equation assume the following Price - $100 Sales forecast - $ 10,000 Variable cost rate - $ 80 Fixed expenses - $100,000 Working capital rate - $ 12 Total fixed capital - $500,000 Based on the above planned rate of return would be: 100(10,000) - 80(10,000) - 100,000 ROI = = 12(10,000) + 500,000 1,000, , , ,000 = = 16.12% 120, , ,000 This formula makes clear that a rate of return is dependent on many different kinds of decisions. To achieve a satisfactory rate of return, management must make good decisions in all aspects of the business including good management of working capital and investment in plant and equipment. Summary Return on investment is primarily a performance evaluation tool. As a decisionmaking tool it is somewhat limited. However, for certain decisions such as starting a new business or expanding an existing businesses, ROI can be very helpful. If management has a goal or objective of earning no less than a return of 20% and under the most optimistic of assumptions, the return will not be greater than 15%, then proposed venture should not be taken. Return on investment is also an excellent tool to use in connection with comprehensive business budgeting. Every comprehensive budget has inherent within it a planned rate of return. This rate of return should be explicitly recognized. The terminology that is important in this chapter is the following: 1. Earnings 8. Debt capital 2. Return on investment-assets 9. Equity capital 3. Return on investment-equity 10. Total assets 4. Interest 11. Leverage 5. Net income 12. Profit margin percentage 6. Net operating income 13. Investment turnover 7. Working capital

9 Management Accounting 313 Q What is the purpose of computing a rate of return? Q What is the basic return on investment equation? Q If investment is defined as total assets, then earnings should be defined how? Q If investment is defined as total equity, then earnings should be defined how? Q If earnings is defined as net income then investment should be defined how? Q If earnings is defined as net operating income, then investment should be defined how? Q What adjustments should be made to net income in order to arrive at net operating income? Q Which concept of ROI eliminates the effect of leverage? Q What is the du Pont ROI formula? Q Explain the meaning of profit margin percentage. Q Explain the meaning of the investment turnover ratio. Q Explain the meaning of the following: A. E/I B. NI/TE C. NOI/TA D. E/S E. S/I

10 314 CHAPTER SIXTEEN Return on Investment Exercise 16.1 Computing Return on Investment You have been provided the following information: Balance Sheet Assets $1,000 Liabilities $ 100 Capital $ 900 Income Statement Required: Sales $2,000 Operating expenses $ 1,850 Interest 10 Taxes 56 Total expenses $1,916 Net income $ Compute ROIa 2. Compute ROIe 3. What effect does the amount of debt relative to equity have on return on investment (equity)? 4. What effect does the amount of debt relative to equity have on return on investment (assets)?

11 Management Accounting 315 Exercise 16.2 Computing Return on Investment You have been provided the following information: Balance Sheet Income Statement Assets $100,000 Sales $500,000 Liabilities $ 20,000 Expenses: Stockholders Equity $ 80,000 Selling $300,000 Administrative 100,000 Taxes 36,000 Interest 2, ,000 Net income $62,000 Interest rate on debt is 10%. Required Based on the above information compute the following 1. Return on investment-assets 2. Return on investment-equity 3. Assuming return on investment-assets: Profit margin percentage Investment turnover 4. If equity is reduced by $60,000 and debt is increased by $60,000 net income would then become $? Return on investment-equity then becomes _?

12 316 CHAPTER SIXTEEN Return on Investment Exercise 16.3 Computing Return on Investment You have been provided the following information: Required: 1. Compute ROIa 2. Computer ROIe Balance Sheet Assets $1,000 Liabilities $ 900 Capital $ 100 Income Statement Sales $2,000 Operating expenses $1,850 Interest $ 90 Total expenses $1,940 Net income $ What effect does the amount of debt relative to equity have on return on investment (equity)? What condition is necessary in order for the principle of leverage to increase the rate of return. 4. What effect does the amount of debt relative to equity have on return on investment (assets)?

13 Management Accounting 317 Problem 16.1 Return on Investment Case I Assets Current $600 Fixed 400 $1,000 Liabilities Current $ 0 Long term 100 $ 100 Capital Common stock 900 Retained earnings 900 $1,000 Sales ($20 x 100) $2,000 Variable cost ($12 x 100) $1,200 Fixed expenses 650 1,850 Net operating income 150 Interest 10 Net income $ 140 Interest rate = 10% Required: 1. Based on the information presentation in Case I, compute the following: Return on Investment (equity) Return on Investment (assets) ROIe ROIa Profit margin % Profit margin% Investment turnover Investment turnover 2. Assume that long term liabilities originally were $900 and that common stock was $100. Based on these changes, compute the following: Return on Investments (equity) Return on Investment (assets) Net income Net operating income ROI(e) ROI(a) Profit margin % Profit margin % Investment turnover Investment turnover Explain why there is a change in ROIe but not ROIa. 3. Assume that units sold are increased by 50%. Compute the following: Return on Investments (equity) Return on Investment (assets) Net income Net operating income ROIe ROIa Profit margin % Profit margin % Investment turnover Investment turnover Observations:

14 318 CHAPTER SIXTEEN Return on Investment Case II Assets Current $600 Fixed 400 $1,000 Liabilities Current 0 Long term Capital Common stock $900 Retained earnings _ $ 900 $ 1,000 Sales ($20 x 100) $2,000 Variable cost ($12 x 100) 1,200 Fixed expenses 700 1,900 Net operating income 100 Interest 10 Net income $ 90 Based on the information in Case II, compute the following: Return on Investments (equity) Return on Investment (assets) Net income _ Net operating income ROIe _ ROIa Profit margin% _ Profit margin % Investment turnover _ Investment turnover Explain why there is no difference in ROIe and ROIa.