Chapter 13 - Financial measures for investment centres Flashcards
Return on investment
a financial measure calculated as profit dividend by invested capital.
Return on investment formula
profit/invested capital
Expanded ROI (components of ROI) formula
profit / sales revenue x sales revenue/invested capital
return on sales x investment turnover
ROI -Invested capital
the assets that the investment centre has available to generate profits.
ROI -Return on sales
The percentage of each sales dollar that remains as profit after all the expenses are covered.
ROI -Investment turnover
The number of sales dollars generated by every dollar of invested capital.
Improving ROI -Increase return sales
Increase the selling price or sales revenue or decrease expenses.
Improving ROI -increase investment turnover
Increase in sales revenue or reduce invested capital.
Improving ROI
Actions that are taken only to make these ratios more favourable in the short term may have adverse effects on performance in future years.
The advantages of ROI
-Encourages managers to focus on both profits and the assets required to generate those profits.
-can be used to evaluate the relative performance of investment centres even when those business units are different sizes.
Limitations of ROI
-May encourage managers to focus on improving short term financial performance (at expense of long term)
-May encourage managers to defer asset replacement, to maintain a high ROI.
-Possible disincentive to invest in new projects that are acceptable from the organisations point of view, but which decrease the investment centres ROI.
Minimising the Behavioural problems of ROI
-use multiple performance measures.
-Consider alternative ways of measuring invested capital.
-use alternative financial measures, such as residual income or economic value added.
Residual income
=profit-(invested capital x imputed interest rate)
RI imputed interest charge:
Based on the required rate of return that the firm expects of its investments, which is based on the organisations cost of capital.
Advantages of RI
- more likely to promote goal congruence, compared to ROI.
-Takes account of the organisation required rate of return in measuring performance.
-encourages investment in projects that yield a positive RI to the organisation.
