B3-FINANCIAL MANAGEMENT-ASSET EFFECTIVENESS AND EFFICIENCY Flashcards
Financial Management
Asset Effectiveness and Efficiency
Return on Investment
Formula
Assessment of a company’s percentage of return relative to its capital investment risk. The ROI is an ideal performance measure for investment in strategic business units (SBUs).
ROI=Net Income/Investment Capital (D+E)
[NI/Avg Assets=Avg PP&E+Avg WC=ROA]
or
ROI=Profit Margin x Investment Turnover
[ROI=NI/Sales(profit margin) X Sales/Assets(investment turnover)=ROA]
Financial Management
Asset Effectiveness and Efficiency
Return on Assets
Formula
is similar to ROI, except that ROA uses average total assets in teh denominator rather than invested capital.
ROA = Net Income / Average Total Assets
Financial Management
Asset Effectiveness and Efficiency
Return on Investment
Limitations
- Short-Term Focus-use of ROI exclusively as a measure of the performance can inadvertently focus managers purely on maximizing short-term returns.
- Investment Myopia-overemphasis of managers on investment balances
- Balanced Scorecard-focus managers on business process, customer, and human resource issues.
- Disincentive to Invest-profitable units are reluctant to invest in additional productive resources because their short-term result will be to reduce ROI. “Takes time for the asset to produce sales”
Return on Equity
Critical measure for determining a company’s effectiveness
ROE=
Net Income/Total Equity (assets minus liabilities)
Components of Dupont ROE
- Net Profit Margin- measure of operating efficiency
* Net profit margin= net income/ sales* - Asset Turnover measure of the degree of efficiency with which a company is using its assets Asset turnover=sales/avg total assets
- Financial Leverage measures the extent to which a company uses debt in its capital structure
* Financial leverage=Avg Total Assets/Equity*
* DuPont ROE = Net Profit Margin x Asset Turnover x Financial Leverage*
* = Net Income x Sales x Average Total Assets*
* Sales Avg Total Assets x Equity*
*Note that Net Profit Margin and Asset Turnover can be multiplied to calculate return on assets (ROA). Therefore, Dupont ROE can also be calculated as:
Dupont ROE = ROA x Financial Leverage
Extended Dupont Model
Further breaks out net profit margin into three distinct components
- Tax Burden-extent to which a company retains profits after paying taxes
* Tax Burden=Net income/pretax income* - Interest Burden-how much in pretax income a company retains after paying interest to debt holders.
* Interest Burden=pretax income/EBIT* - Operating Income Margin-measure of company profits earned on sales after paying operating costs.
* Operating Income Margin=EBIT/Sales*
* 4. Asset Turnover*
* 5. Financial Leverage*
* Extended DuPont ROE*
* = Tax Burden x Int Burden x Operating Inc. Margin x Asset Turnover x Financial Leverage*
* = Net Income x Pretax Inc x EBIT x Sales x Average Total Assets*
* Pretax Inc EBIT Sales Avg Total Assets Equity*
*Both methods of calculating ROE produce the same number. However, by breaking out the calculation into different components, management can get a better understanding of what factors are driving ROE and how those factors compare relative to competing companies and to the industry overall.
Residual Income
The residual income method measures the “excess” of actual income earned by an investment over the return required by the company. ROI provides a percentage measurement, residual income provides an amount. Like ROI, residual income is a performance measure for investment SBUs.
Formula
- Residual Income =*
- Net Income (from the Income Statement) - Required Return “In $ on equity”*
- Where: Required Return = Net Book Value Equity x Hurdle Rate*
Economic Value Added
EVA method of performance evaluation is very similar to the residual income method. The RI method computes required return based on a hurdle rate determined by management, and the EVA measures the excess of income after taxes (not counting interest expense) earned by an investment over the return rate defined by the company’s overall cost of capital. EVA ensures that performance is measured in comparison to changes in comparison to changes associated with all capital, debt, and equity.
EVA=NOPAT-$(Dollar amount of Debt + Equity) xWACC
Step 1: Calculate the required amount of return and income after taxes
Investment x cost of Capital= Required Return in dollars
Step 2 Compare income to required return
Net operating profit after taxes (NOPAT)-Required Return=Economic Value Added in dollars
EVA vs Residual Income
- EVA-return to all providers of capital
Residual Income-looks at just the return available to the stockholders
- More flexible than RI-EVA can be refined using investment or income adjustments to produce a more accurate analysis of economic profit (value added).
EVA
NOPAT (EBIT x 1-T)-required return ($WACC)
Postive Vs Negative EVA
Positive-increase stock price Negative-decrease
Importance of Debt-to-Total Capital Ratio
Provides indications related to an organizations long-term debt-paying ability. The lower the ratio, the greater the level of solvency and the greater the presumed ability to pay debts.
Financial Mgmnt
Effectiveness of L-T Financing
Debt-to-Assets Ratio
Total Debt / Total Assets
If you have a lower ratio, less risk b/c you don’t have a lot of debt. But this means you have more equity which means a lower return on equity.
This ratio indicates long-term debt paying ability. The lower the ratio, the better protection afforded to creditors.
Debt-to-Equity Ratio
1+D/E=DFL
Dupont= A/E
provides more refined view of solvency.
related two major categories of capital structure to each other and indicates the degree of leverage used. The lower the ratio, the lower the risk involved.
Times Interest Earned Ratio
=Earnings before Interest and Taxes (EBIT)/Interest Expense
Measures the ability of the company to pay its interest charges as they come due. It is a measure of long term solvency.
When high=means risk is low. Conversely, low interest implies less debit. Implies you got your money from equity than you have high equity which means you have a lower return on equity.
Financial Mgmnt
Effectiveness of L-T Financing
Debt-to-Total-Capital Ratio
Total Debt / Total Capital (D+E)
measure of financial leverage-risk
Financial Management
Asset Effectiveness and Efficiency
Return on Investment
Limitations
Residual Income Method Issues
Benefits of RI Performance Measures
vs
Weaknesses
Benefits
- Ease of measurement of actual dollars earned by an investement above its required amount
- Realistic Target Rates “In dollars” - target rate in residual income method will be less than the highest return rates actually earned by the best-performing investment centers in a company. Historical weighted average cost of capital is often used s the target or hurdle rate; however, the rate optimally used is the target return set by the company’s management.
- Focus on Target Return and Amount “In dollars”-RI income controls and performance meausres encourage managers to invest in projects that generate income in excess of the target or calculated rate, thereby improving company profits and promoting the congruence of individual and corporate goals. Divisions with high rates of return do not fear dilution of their rates and, therefore, do not avoid investments that demonstrate strong residual income performance.
Weaknesses
- Reduced Comparability-Use of an absolute amount to compute performance distorts comparison of units with unequal size. Larger units of an org may produce larger dollar volumes of residual income even though their performance is identical to a smaller unit on a percentage basis.
- Target Rates Require Judgment- subjective-reliance on computing a target rate of return may sometimes be difficult to establish.
