Performance Management Pt. 2 Flashcards
What is return on investment (ROI)?
it provides for the assessment of a company’s percentage return relative to its capital investment risk; the ROI is an ideal performance measure for investment strategic business units SBUs); the higher the denominator, the lower the return
ROI = income / investment capital
OR
ROI = profit margin [income / sales] * investment turnover [sales / invested capital]
What is return on assets (ROA)?
it is similar to ROI except that ROA uses average total assets
ROA = net income / average total assets
asset valuations used in ROI and ROA computations affect the results; the appropriate asset value depends on the strategic objectives of the company and the direction that leadership wants to give its managers; below are different asset valuation types:
NBV, gross book value, replacement cost, and liquidation value
What are two major limitations for ROI?
it has a short-term focus and there’s a disincentive to invest; it is designed to direct managers to achieve corporate objectives and provide a basis for incentives like any other performance measure
What is return on equity (ROE)?
it is a critical measure for determining a company’s effectiveness
ROE = net income / equity
the 3 step DuPont model breaks ROE into 3 distinct components: net profit margin, asset turnover, and financial leverage
net profit margin = net income / sales
asset turnover = sales / assets
financial leverage = assets / equity
the DuPont ROE is calculated by multiplying the 3 components together (also can be calculated by: ROA * financial leverage)
Extended DuPont Model
this further breaks out net profit margin into 3 distinct components: tax burden, interest burden, and the operating income margin; but the last two components of the ROE calculation remain the same
tax burden = net income / pretax income
interest burden = pretax income / earnings before interest and taxes [EBIT]
EBIT margin = EBIT / sales
both methods of calculating ROE (DuPont and extended DuPont) produce the same number; the extended allows management to further understand what factors are driving ROE and how those factors compare relative to competing companies and to the industry overall
What is residual income (RI)?
it measures the excess of actual income earned by an investment over the return required by the company; the rate of return/hurdle rate for the company may be its WACC, cost of equity, or it may simply be the return established by management as a target rate
although ROI provides a percentage measurement, RI provides an amount; like ROI, RI is a performance measure for investment SBUs
RI = net income - required return
where
required return = NBV (equity) * hurdle rate
positive RI = performance is meeting standards
negative RI = performance is not meeting standards
What are some strengths/weakness of RI?
strengths: realistic target rates and focuses on target return and amount
weaknesses: reduced comparability and target rates require judgment
What is economic value added (EVA)?
it is very similar to RI; EVA measures the excess of income after taxes earned by an investment over the return rate defined by the company’s overall cost of capital (WACC); it ensures that performance is measured in comparison to changes associated with all capital, debt, and equity; it is expressed as an amount and is considered a form of economic profit
EVA = net operating profit after taxes [NOPAT] - required return
where
required return = investment * WACC
positive EVA = performance is meeting standards
negative EVA = performance is not meeting standards
