Management Accounting
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
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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
800,000
–––––––––
––––––––––
Net operating income
$ 200,000
Interest
$100,000
Taxes
40,000
140,000
–––––––––
––––––––––
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
Management Accounting
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 = –––––––––––––––––––
Total assets
(1)
Net income
ROIe = –––––––––––
Total equity
(2)
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
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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
2,000
ROIa = –––––– = 23%
ROIe = –––––– = 25%
10,000
8,000
Management Accounting
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:
ROI =
Earnings
––––––––– x
Sales
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:
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Company A
300,000 1,000,000
ROI = –––––––– x ––––––––
1 ,000,000
500,000
= 30% x 2 = 60%
Company B
200,000 1,000,000
ROI = ––––––––– x ––––––––– = 20% x 4 = 80%
1,000,000 250,000
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
Furniture stores
Discount stores
Gasoline stations
Petroleum refining
1.0%
2.5%
2.0%
4.5%
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 –––––– =
10,000 10,000
.2 x 1 = 20%
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
Management Accounting
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
Project A
Project B
Net income
1
$10,000
$20,000
2
$10,000
$15,000
3
4
5
Total
$10,000
$10,000
$10,000
$ 2,500
$10,000
$ 2,500
$50,000
$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
equation:
ROI
ROI
P(Q) - V(Q) - F
= ––––––––––––––––
C(Q ) + FC
=
E/I, we now have the following
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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 - 800,000 - 100,000
–––––––––––––––––––––––––––––– =
120,000 + 500,000
100,000
–––––––
620,000
=
= 16.12%
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
Management Accounting
Q. 16.1
What is the purpose of computing a rate of return?
Q. 16.2
What is the basic return on investment equation?
Q. 16.3
If investment is defined as total assets, then earnings should be defined
how?
Q. 16.4
If investment is defined as total equity, then earnings should be defined
how?
Q. 16.5
If earnings is defined as net income then investment should be defined
how?
Q. 16.6
If earnings is defined as net operating income, then investment should
be defined how?
Q. 16.7
What adjustments should be made to net income in order to arrive at
net operating income?
Q. 16.8
Which concept of ROI eliminates the effect of leverage?
Q. 16.9
What is the du Pont ROI formula?
Q. 16.10
Explain the meaning of profit margin percentage.
Q. 16.11
Explain the meaning of the investment turnover ratio.
Q. 16.12
Explain the meaning of the following:
A.
B.
C.
D.
E.
E/I
NI/TE
NOI/TA
E/S
S/I
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314 | CHAPTER SIXTEEN • Return on Investment
Exercise 16.1 • Computing Return on Investment
You have been provided the following information:
Balance Sheet
Assets
Liabilities
Capital
$1,000
$ 100
$ 900
Income Statement
Sales Operating expenses
$ 1,850
Interest
10
Taxes
56
–––––––
Total expenses
Net income
Required:
$2,000
$1,916
–––––––
$ 84
–––––––
1.
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)?
Management Accounting
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
438,000
––––––––
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 _ _____________________ ?
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Exercise 16.3 • Computing Return on Investment
You have been provided the following information:
Balance Sheet
Assets
Liabilities
Capital Income Statement
$1,000
$ 900
$ 100
Sales
Operating expenses
$1,850
Interest
90
__$_____
$2,000
Total expenses
Net income
_$1,940
_
_____
$
60
__
_______
_____
Required:
1. Compute ROIa
2. Computer ROIe
3. 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)?
Management Accounting
Problem 16.1 • Return on Investment
Case I
Assets
Current
$600
Fixed
400
______
Liabilities
Current
$ 0
Long term
100
______
Capital
Common stock
900
Retained earnings
Sales ($20 x 100)
$1,000
___
_____
____
$ 100
900
_ _____
$1,000
______
______
$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)
ROIe
__________
Profit margin %
__________
Investment turnover __________
Return on Investment (assets)
ROIa
__________
Profit margin%
__________
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)
Net income
ROIe
Profit margin %
Investment turnover
Return on Investment (assets)
__________
__________
__________
__________
Net operating income ROIa
Profit margin %
Investment turnover
__________
__________
__________
__________
Observations:______________________________________________________
_____________________________________________________________________
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Case II
Assets
Current
$600
Fixed
400
______ Liabilities
Current
0
Long term
100
Capital
Common stock
$900
Retained earnings
Sales ($20 x 100)
$1,000
_______
_______
100
900
_$______
1,000
__$______
______
Variable cost ($12 x 100)
Fixed expenses
Net operating income
Interest
Net income
$2,000
1,200
700
_______
1,900
_ ______
100
10
_______
$ 90
_______
_______
Based on the information in Case II, compute the following:
Return on Investments (equity) Return on Investment (assets)
Net income
ROIe
Profit margin%
Investment turnover
_________
_________
_________
_________
Net operating income
ROIa
Profit margin %
Investment turnover
________
________
________
________
Explain why there is no difference in ROIe and ROIa.
_____________________________________________________________________
_____________________________________________________________________