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Essentials of CORPORATE PERFORMANCE MEASUREMENTThe Importance of Return on InvestmentThe Accounting EquationAssets=Debt +Owners equity

Investment in assets = Investment +Investment by creditors by owners

What is Profitability?The state or condition of yielding a financial profit or gain.

Earnings are determined by subtracting a companys business expensessalaries, interest, the cost of goods sold.Imaginary Company Income Statement for the Year Ended December 31, 2013Scene 1Scene 2SalesP25,000,000Expenses(24,500,000)ProfitP500,000SalesP3,125,000Expenses(2,625,000)ProfitP500,000What is Return on Investment?A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.

To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

The return on investment formula:ROI = Profit / Investment

Imaginary CompanyLet us assume investment to be,

a.) P20,000,000.

b.) P2,000,000

How can ROI be useful?ROI is the principal tool used to evaluate how well (or poorly) management performs.

For Creditors and Owners

Assess the companys ability to earn an adequate rate of return.

Provide information about the effectiveness of management.

Project future earnings.

For Managers

Measure the performance of individual company segments when each segment is treated as an investment center.

Evaluate capital expenditure proposals.

Assist in setting management goals.Using ROI to analyze performanceLet us consider, for example, two hypothetical managers of companies earned a profit of P20,000 on an investment of P100,000, to produce ROIs of 20 percent.

Smith Company : ROI = P20,000/P100,000 = 20%

Jones Company : ROI = P20,000/P100,000 = 20%Relationship between Profit Margin and Asset Turnover

Lets imagine that both companies are retail jewelers.

Smith Company sells inexpensive custom jewelry in malls throughout the country. Smith Company follows a high-volume, low mark-up approach to marketing. Thus, the profit margin on Smith Company sales is only 4 percent, calculated as follows:

Profit margin on sales = profit/sales = P20,000/P500,000 = 0.04Smith Company turns its assets over rapidly. Analysts calculate it by dividing an asset into the best measure of the assets activity. If Smith Company creates sales of P500,000 with its investment of P100,000, its asset turnover is 5 times per year, calculated as follows:

Asset (or Investment) Turnover = Sales/Investment =P500,000/P100,000 = 5 timesROI = Asset turnover x Profit margin on sales = (Sales/Investment) x (Profit/Sales) = P500,000/P100,000xP20,000/P500,000 = 5 timesx0.04ROI = 20% Jones Company does not operate the same as Smith Company.

Jones Company sells expensive, one-of-a-kind jewelry containing large diamonds and other precious stones. Because each piece is unique, Jones Company has low asset activity (turnover) and sells only a small volume of jewelry, but with high profit on each sale. As a result, Jones Company turns its assets over only 1.25 times per year.

Asset Turnover = Sales/Asset = P125,000/P100,000 = 1.25 timesBecause Jones Company turns its assets over more slowly than Smith Company, Jones Company needs a higher profit margin on sales than Smith Company if it is to generate the same ROI. The profit margin on sales for Jones Company is 16 percent. With this markup, Jones Company achieves the same ROI of 20 percent that Smith Company achieved, but by a different combination of turnover (activity) and margin (profitability).The DuPont Method

Return on Equity

The effect of Debt on the ROEROE differs from ROI because a company typically borrows part of its capital. Consider a company that creates a 15 percent ROI, as follows.

ROI = profit/asset = P135,000/P900,00 = 0.15

If all the investment in assets (P900,000) is financed by owners, then owners equity is also P900,00 and ROE is also 15 percent.

ROE = profit/asset = P135,000/P900,00 = 0.15

But if one-third of the investment in assets is borrowed, and owners equity is only P600,000, ROE is increased to 22.5 percent. If half the assets are from borrowed capital, ROE rises to 30 percent. At three-quarters debt, ROE is 45 percent.

The proportion of assets obtained by debt financing rather that owner investment is quite important, because debt leverages the owners equity.The effect of debt on solvencyRatios of debt and equity are called solvency o leverage ratios. Examples include debt to owners equity and debt to total equities. Debt and equity ratios determine the relative sizes of the property rights of creditors and owners. Too much debt restricts manager and increases the risk of owners because debt increases the fixed charges (interest expense) against income each period.

As the portion of debt rises, creditors are more and more reluctant to lend. Eventually, credit will be available only at very high interest rates. Still, a certain amount of debt is good for owners because managers use debt to increase ROE.ROI, ROE, SolvencyROI = Investment Turnover x Profit Margin on Sales

ROE = Investment x Profit Margin x solvency Turnover on Sales

ROE = Sales x Income x Investment InvestmentSalesOwners Equity

Advantages of ROIBecause it is a percent and thus easy to understand and consistent with how a company measures its cost of capital.

ROI normalizes activities and makes dissimilar activities comparable.

ROI as a Comprehensive ToolROI is a comprehensive measure, affected by all the business activities that normally determine financial health. ROI is increased or decreased by the level of operating expenses incurred, and by changes in either sales volume or price. The investment base can include capital investment in PPE or current investments such as inventories and receivables.

Many managers think ROI is useful because it provides a means of monitoring the results of capital investment decisions: If a project does not earn its projected return, the managers ROI goes down.Other TopicsGearing Investment and Profit

The Drawbacks of Targeting an ROI

Accounting Methods, Timing, and ManipulationROI and Decision MakingProfit-Neutral, Nondiscretionary InvestmentInvestments that do not create increase in profit.

Replacing or upgrading administrative or support facilities.

ROI and BudgetingAlthough ROI provides an incentive to managers to ignore company goals and avoid some profitable investment, the planning process can help resist this temptation.

In annual planning,First Budget sales prices and quantities, then the costs of planned sales.Next - Determine additional investment needed, for inventory and/or fixed assets.Finally - Target ROI is set by dividing budgeted profit by budgeted asset.Determining Profit and the Investment BaseMeasuring Profit

Determining Investment Base What assets should be included? What liabilities should be deducted?How should assets be valued?Measuring Profit

Profit in published FS is determined using generally accepted accounting principle (GAAP).

GAAP-based information is useful for stockholders and others in assessing the performance of the companys operating segments, but is not useful in assessing the performance of segment managers.What assets should be included?

Deciding what assets to include will depend, in part, on whether top management is evaluating a segments manager or the economic performance of the segment. The issue is much the same for investment as it is for profit. If the economic performance of the segment is assessed, segment investment should include all capital dedicated to its mission, regardless of who manages the investment. But if instead the segment managers performance is assessed, only those components of investment controlled by the manager should be included.

What liabilities should be deducted?

Total Assets

Total Assets minus Current Liabilities

Total Assets minus all Liabilities

How should assets be valued?Gross book value uses historical or acquisition cost of assets.Disposal DecisionsReplacement Decisions

Net Book Value gross book value minus accumulated depreciation, amortization and depletion.

Replacement Cost estimated cost of replacing the asset.Replacement Value As Is.Replacement Value New.Capacity Replacement Value.Price-Level Adjusted Historical Cost.

Economic book value uses the present value of future cash flows.

You are a house flipper. You purchased a house at the courthouse auction for $75,000 and spent 35,000 in renovations. After sales expenses and commission, you netted $160,000 on the sale of the renovated house. What is the ROI?ROI = Net Profit/Total Investment x 100ROI = 50,000/160,000 x 100ROI = 50,000/160,000 x 100ROI = .31 x 100ROI = 31%

CP Inc. is a company engaged in production and distribution of computers and printers. It has two main operating departments: department C specializes in design, production and marketing of computers and Department P deals in printers.Department C has earned net operating profit of $300 million for the FY 2011 while department P has earned operating profit of $130 million for the same period. Department C had opening operating assets of $1 billion and its closing operating assets are $1.1 billion while department P had opening operating assets of $0.5 billion while its closing operating assets are $0.7 million.CP Inc. has minimum return requirement of 12%.

Which of the two department perform better based on their ROI?

SolutionDepartment C's average operating assets are $1.05 billion while department P's average operating assets are $0.6 billion.Department C has a return on investment (ROI) of 28.6% ($300 million/$1,050 million) while department P has return on investment (ROI) of 18.6% ($130 million/$700 million).It tells that department C has performed better than department P. Since the minimum return is 12%, ROI also tells that both the departments have met the minimum return requirement.

A business purchases a new form of information system technology for $500,000. Because of this purchase, the company begins earning $50,000 a year. Find the ROI for the first year. Explain your answer.ROI = 50,000 500,000= 450,000= 0.9 100 =90%500,000 500,000

What does a negative ROI mean? Lets take a step back and think about a different question: what would it mean if we had a zero ROI? This only occurs when the numerator of our formula is zero, and this can only happen if our gains were the same as our costs, meaning we broke even. Therefore, if ROI is negative, the costs must be greater than the gains, or we have yet to achieve an amount of gain great enough to cover the cost of the investment. Once ROI is positive, that means we have earned more than the cost we put into the investment. When its positive, we have actually returned a profit!

Investors calculate ROI over time to see how the value changes or when a positive ROI will occur. This gives them a better timeframe of how long it will take them to get an adequate return on their purchase.