Return on Investment Ratio Analysis

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Ratio Analysis

Ratio analysis may be carried out using any of the two approaches.

  1. Trend/Time Series Analysis: This involves computing ratios and comparing them with the previous year’s ratios of the same coy to assess the performance of the company.
  2. Cross-Sectional Analysis: This approach entails computing ratios of a company and comparing them with the average of the industry in which the company operates to assess the performance of the company.

Based on these two approaches, the references point to which ratios of the coy may be compared include:

  • Previous years ratios
  • The average industry
  • Inter-company analysis.

Once you have read a case, a good place to begin your analysis is with the financial statements. Ratio analysis is the calculation of ratios from data statements. It is done to identify possible financial strengths or weaknesses.

Thus, it is a valuable part of SWOT Analysis. A review of key financial ratios can help you assess a company’s overall situation and pin-point some problem areas. Ratios are useful, regardless of firm size, and they enable you to compare a company’s ratios with industry averages.

Lists some of the most important financial ratios are:

Analyzing Financial Statements

In your analysis, do not simply make an exhibit that includes all the ratios (unless your instructor requires you to do so), but select and discuss only those ratios that have an impact on the company’s problems.

For instance, accounts receivable and inventory may provide a source of funds. If receivables and inventories are double the industry average, reducing them may provide needed cash. In this situation, the case report should not include nor only sources of funds but also the number of dollars freed for use.

Compare these ratios with industry averages to discover whether the company is out of line with others in the industry. Annual and quarterly industry ratios can be found in the library or on the internet.

A typical financial analysis of a firm would include a study of the operating statements for five or so years, including trend analysis of sales, profits, earnings per share, debt-to-equity ratio, and return on investment and so on. Then, plus a ratio study comparing the firm understudy with industry standards. As a minimum, undertake the following five steps in basic financial analysis.

  • Determine the change as a percentage as well as an absolute amount.
  • Adjust for inflation if that was a significant factor.
  • Scrutinize historical income statements and balance sheets. These two basic statements provide most of the data needed for analysis. Statements of cash flow may also be useful.
  • Compare historical statements over time if a series of statements is available.
  • Calculate changes that occur in individual categories from year-to-year as well as the cumulative total change.

Examination of this information may reveal developing trends. Compare trends in one category with trends in related categories. For example, an increase in sales of 15% over three years may appear to be satisfactory’ until you note an increase of 20% in the cost of goods sold during the same period.

The outcome of this comparison might suggest that further investigation into the manufacturing process is necessary. If a company is reporting strong net income growth but negative cash flow this would suggest that the company is relying on something other than operations for earnings growth. Is it selling off assets or cutting R&D?

If an account receivable is growing faster than are sales revenue, the company is not getting paid for the producers or services it is counting as sold. Is the company dumping product on its distributors at the end of the year to unordered product the next month, thus drastically cutting the next year’s reported sales.

The analysis of a multinational corporation’s financial statements can get very complicated, especially if its headquarters is in another country that uses different accounting standards.

Return On Investment (ROI)

After the company, divisions have been established and the related authorities and responsibilities assigned and the adequate system must be developed for measuring the performance of both the divisions and the division managers.

There are many approaches to an evaluation program. Their selection depends on the needs of the enterprise and the wishes of management.

For example, should performance be gauged in terms of net income net sales or net income about investment? Should income after income taxes or income before income taxes be used? Should the basis of measurement for the divisions be the same as that for the company as a whole? No one answer will suit the needs of all companies. However, one of the most common methods of performance measurement in use is the return on investment (ROI).

Return-On-Investment or Return-On-Capital method has been used for many years by banks to measure the performance of borrowers. The rate of return on investment for the total company is usually computed by dividing net income by total assets.

Total assets may be referred to as an investment, invested capital employed, etc (the terms are often used interchangeably).

The ROI method has many important advantages over most other methods. It is simple to compute and can be used to measure and compare divisional or company performance returns on competing company’s returns on competing for capital projects, and many other factors, thereby permitting management to select the most favorable option from alternatives.

Return On Investment Ratio

A simple way to express the return on investment is by an equation. The ROI equation is generally shown m two pans, the investment turnover, and the earnings ratio. The investment turnover is stated as:

Investment Turnover =    Sales/Total Assets Employed

The earnings ratio shows the sales – expense relationship and is stated as:

Earnings Ratio =  Net Income/Sale

Investment turnover indicates management’s efficiency in using available assets to generate sales volume and earnings. The earnings ratio indicates the percentage of profit in each dollar of sales.

The ROI equation is made up of both the above components:

ROI = Investment Turnover x Earnings Ratio

Upon superficial examination, it appears that the equation could be simplified canceling out sales in the two components. If this were done, however, the independence of the two separate variables investment turnover and earnings ratio would be lost.

Advantages of ROI Method

The advantages of this method are that ROI can

  • Help make the goals of the division manager coincide with those of corporate management.
  • Provide a means for objective comparison of various internal performance results among divisions and with projected external performance results.
  • Help division managers evaluate and improve their performance.
  • Provide an incentive to use existing assets to their full extent, thereby limiting the acquisition of additional resources to those which will increase the return on investment ratio.
  • Act as a comprehensive measure sensitive to every influence affecting the financial status of a company.
  • Focus management’s attention upon maximizing earnings on invested capital (total assets employed).
  • Serve as a basis for measuring management’s performance in utilizing total assets as well as divisional resources.

Disadvantages of ROI Method

  • A division manager may be reluctant to acquire additional investments that might lower the ROI.
  • Division managers may make decisions that help raise the divisional ROI ratio but which are not good for the long-term interest of the company.
  • It focuses on maximizing a ratio rather than improving absolute profit mounts.
  • The established rate of return may be too high and could discourage divisional incentive.

Total Company Evaluation

Company evaluation is often used where one company wishes to compare return investment with that of another company, for example, a competitor. It is an external evaluation rather than the internal evaluation done in divisional performance.

Total data for companies can generally be obtained from such published reports as the annual report to stockholders or the Securities and Exchange Commission.

Generally, only final results such as net sales, net income are needed, and the invested capital is the total assets used in business. Their differences of opinion over which figures should be included for some of the factors of the equation. For example, should net income be used or would it be better to use operating income so that non-operating expenses and income are deleted?

Care must be exercised in making comparisons between companies when further data are lacking. Such comparisons may be distorted for example entirely different products or divisions are included in the totals.

Divisional Evaluation

The ROI concept has proved to be very effective for internal evaluation in many industrial companies. For a company to obtain maximum results from decentralization, constant monitoring of divisional operations is essential. The past central management was mostly concerned with dollar sales, dollar earnings, and profit margins. Generally, the operating income figure is used in comparing divisional results. The non-operating expense and income would generally be maintained on the headquarters books. The divisional ROI equation is usually stated as:

ROI = (Divisional Sales  x Divisional Operating Income)/(Divisional Assets Employed x Divisional Sale)

Or

ROI = (Divisional Investment Turnover x Divisional Earnings Ratio)

Residual Income

One of the stated shortcomings of ROI is its emphasis on the rate of return rather than on absolute dollars. To overcome this, some companies use a target rate or imputed-interest rate, and the excess of net income above this figure is considered the residual income.

The formula is

Residual Income = Net Income – (Investment x Imputed – Interest Rate)

An important advantage of this method is that a particular division may expand as long as it earns a rate over the charge for invested capital (imputed interest). Under this method, managers generally concentrate on increasing dollars rather than improving only the ROI percentage rate.

Risk and Return

The return from holding an investment over some period-say, a year-is says any cash payments received due to ownership, plus the change in market price divided by the beginning price. For example, buy for $100 a security would pay $7 in cash to you and be worth $106 one year later. The return would be ($7 + $6)/$100) = 13%. Thus, the return comes to you from two sources: income plus price appreciation (or loss in price).

 

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