Chapter 8

Return on Invested Capital

REVIEW
Return on invested capital is important in our analysis of financial statements. Financial
statement analysis involves our assessing both risk and return. The prior three chapters
focused primarily on risk, whereas this chapter extends our analysis to return. Return on
invested capital refers to a company's earnings relative to both the level and source of
financing. It is a measure of a company's success in using financing to generate profits,
and is an excellent measure of a company's solvency risk. This chapter describes return
on invested capital and its relevance to financial statement analysis. We also explain
variations in measurement of return on invested capital and their interpretation. We also
disaggregate return on invested capital into important components for additional insights
into company performance and future operations. The role of financial leverage and its
importance for returns analysis is examined. This chapter demonstrates each of these
analysis techniques using financial statement data.

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8-1

OUTLINE

Importance of Return on Invested Capital

Measuring Managerial Effectiveness
Measuring Profitability
Measure of Forecasted Earnings
Measuring for Planning and Control

Components of Return on Invested Capital

Defining Invested Capital
Defining Income
Adjustments to Invested Capital and Income
Computing Return on Invested Capital

Analyzing Return on Assets

Disaggregating Return on Assets
Relation between Profit Margin and Asset Turnover
Asset Turnover Analysis

Analyzing Return on Common Equity

Disaggregating Return on Common Equity
Computing Return on Invested Capital
Assessing Growth in Common Equity
Financial Leverage and Return on Common Equity
Return on Common Shareholders' Equity versus Investment

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Financial Statement Analysis, 8th Edition

ANALYSIS OBJECTIVES

Describe the usefulness of return measures in financial statement analysis.

Explain return on invested capital and variations in its computation.

Analyze return on total assets and its relevance in our analysis.

Describe disaggregation of return on assets and the importance of its components.

Analyze return on common shareholders' equity and its role in our analysis.

Describe disaggregation of return on common shareholders' equity and the

relevance of its components.

Explain financial leverage and how to assess a company's success in trading on

the equity across financing sources.

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8-3

QUESTIONS
1. The return that is achieved in any one period on the invested capital of a company
consists of the returns (and losses) realized by its various segments and divisions. In
turn, these returns are made up of the results achieved by individual product lines
and projects. A well-managed company exercises rigorous control over the returns
achieved by each of its profit centers, and it rewards the managers on the basis of
such results. Specifically, when evaluating new investments in assets or projects,
management will compute the estimated returns it expects to achieve and use these
estimates as a basis for its decision to invest or not.
2. Profit generation is the first and foremost purpose of a company. The effectiveness of
operating performance determines the ability of the company to survive financially, to
attract suppliers of funds, and to reward them adequately. Return on invested capital
is the prime measure of company performance. The analyst uses it as (1) an indicator
of managerial effectiveness, (2) a method of projecting earnings, and/or (3) a measure
of the company's ability to earn a satisfactory return on investment.
3. If the investment base is defined as comprising total assets, then income before
interest cost is used. The exclusion of interest from income deductions is due to its
being regarded as a payment for the use of money from the suppliers of debt capital
(in the same way that dividends are regarded as a payment to suppliers of equity
capital). Income before deductions for interest and dividends is used when it is
related to total assets and to long-term debt plus equity capital (assuming the interest
expense is related to long-term debt).
4. First, the motivation for excluding nonproductive assets from invested capital is
based on the idea that management is not responsible for earning a return on nonoperating invested capital. While this may be valid for internal analysis, external
analysts must include these amounts, as they are part of assessing overall
management effectiveness. Second, the exclusion of intangible assets from the
investment base is often due to skepticism regarding their value or their contribution
to the earning power of the company. Under GAAP, intangibles are carried at cost.
However, if their cost exceeds their future utility, they are written down (or there will
be an uncertainty exception regarding their carrying value in the auditor's opinion).
The exclusion of intangible assets from the asset base must be based on more
substantial evidence than a mere lack of understanding of what these assets
represent or an unsupported suspicion regarding their value. This implies that
intangible assets not be excluded from invested capital.
5. The income of a consolidated entity that includes a subsidiary that is partially owned
by a minority interest usually reflects a deduction for the minority's share in that
income. The consolidated balance sheet, however, includes all the assets of such a
subsidiarythat is, those belonging to the parent as well as those belonging to the
minority (see Chapter 5). Because the investment in the denominator includes all the
assets of the consolidated entity, the income (in the numerator) should include all the
income (or loss) of the consolidated entity, not just the parent's share. For this
reason, the minority's share of earnings (or loss) must be added back to income in
computing return on total assets. When the denominator is the equity capital only, the
minority share in income (or loss) need not be added back if this equity capital
excludes minority interest.

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Financial Statement Analysis, 8th Edition

6. The basic formula for computing the return on investment is net income divided by
total invested capital. Whenever we modify the definition of the investment base by,
say, omitting certain items (liabilities, idle assets, intangibles, etc.) we must also
adjust the corresponding income figure to make it consistent with the modified asset
base.
7. The relation of net income to sales is a measure of operating performance (profit
margin). The relation of sales to total assets is a measure of asset utilization or
turnovera means of determining how effectively (in terms of sales generation) the
assets are utilized. Both of these measures, profit margin as well as asset utilization,
determine the return realized on a given investment base. Sales is an important factor
in both of these performance measures.
8. Profit margin, although important, is only one aspect of the return on invested capital.
The other is asset turnover. Consequently, while Company B's profit margin is high,
its asset turnover may have been sufficiently depressed so as to drag down the
overall return on invested capital, leading to the shareholder's complaint.
9. The asset turnover of Company X is 3. The profit margin of Company Y is 0.5%. Since
both companies are in the same industry, it is clear that Company X must concentrate
on improving its asset turnover. On the other hand, Company Y must concentrate on
improving its profit margin. More specific strategies depend on the product and
industry.
10. The sales to total assets (asset turnover) component of the return on invested capital
measure reflects the overall rate of asset utilization. It does not reflect the rate of
utilization of individual asset categories that enter into the overall asset turnover. To
better evaluate the reasons for the level of asset turnover or the reasons for changes
in that level, it is helpful to compute the rate of individual asset turnovers that make
up the overall turnover rate.
11. The evaluation of return on invested capital involves many factors. The
inclusion/exclusion of extraordinary gains and losses, the use/nonuse of trends, the
effect of acquisitions accounted for as poolings and their chance of recurrence, the
effect of discontinued operations, and the possibility of averaging net income are just
a few of many such factors. Moreover, the analyst must take into account the effects
of price-level changes on return calculations. It also is important that the analyst bear
in mind that return on invested capital is most commonly based on book values from
financial statements rather than on market values. And finally, many assets either do
not appear in the financial statements or are significantly understated. Examples of
such assets are intangibles such as patents, trademarks, research and development
activities, advertising and training, and intellectual capital.
12. The equity growth rate is calculated as follows:
[Net income Preferred dividends Common dividend payout] / Average common equity.
This is the growth rate due to the retention of earnings and assures a constant
dividend payout over time. It indicates the possibilities of earnings growth without
resort to external financing. The resulting increase in equity can be expected to earn
the rate of return that the company earns on its assets and, thus, further contribute to
growth in earnings.

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8-5

13. a. The return on total assets and the return on common stockholders' equity differ
by the capital investment base (and its corresponding effects on net income). This
is because a portion of the capital that finances total assets is usually supplied by
creditors who receive a fixed return or, in some cases, no return at all. In a similar
vein, preferred equity usually receives a fixed dividend (much like debt). These
fixed returns differ from the rate earned on the assets that they finance. This is the
concept of financial leverage. In sum, both return measures reflect different
perspectives: ROA reflects that of the entire investment base whereas ROCE
reflects the perspective of common shareholders.
b. ROCE can be disaggregated into the following components to facilitate analysis:
Net income - Preferred dividends
Sales

Sales
Average assets

Average assets
Average common equity

Descriptively, we can express this formula as:

Adjusted profit margin x Asset turnover x Leverage.
The adjusted profit margin represents the portion of a sales dollar that is left for
common shareholders after providing for all costs and claims (including those of
preferred shareholders). The asset turnover measures the relation between sales
and assets required to generate them. Leverage measures the extent that total
assets are financed by common shareholders. The lower the proportion of assets
financed by common stockholders, the greater the extent of leverage.
14. a. ROCE can be disaggregated as follows:
Net income - Preferred dividends
Sales

Sales
Average common equity

This shows that equity turnover (sales to average common equity) is one of the
two components of the return on common shareholders' equity. Assuming a stable
profit margin, the equity turnover can be used to determine the level and trend of
ROCE. Specifically, an increase in equity turnover will produce an increase in
ROCE if the profit margin is stable or declines less than the increase in equity
turnover. For example, a common objective of discount stores is to lower prices
by lowering profit margins, but to offset this by increasing equity turnover by more
than the decrease in profit margin.
b. Equity turnover can be rewritten as follows:
Net operating assets
Sales

Net operating assets

Average common equity

The first factor reflects how well net operating assets are being utilized. If the ratio
is increasing, this can signal either a technological advantage or under-capacity
and the need for expansion. The second factor reflects the use of leverage.
Leverage will be higher for those firms that have financed more of their assets
through debt. By considering these factors that comprise equity turnover, it is
apparent that EPS cannot grow indefinitely from an increase in these factors. This
is because these factors cannot grow indefinitely. Even if there is a technological
advantage in production, the sales to net operating assets ratio cannot increase
indefinitely. This is because sooner or later the firm must expand its net operating
asset base to meet rising sales or else not meet sales and lose a share of the
market. Also, financing new assets with debt can increase the net operating
assets to common equity ratio. However, this can only be pursued to a pointat
which time the equity base must expand (which decreases the ratio).
15. Where convertible debt sells at a substantial premium above par and is clearly held
by investors for its conversion feature, there is justification for treating it as the

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Financial Statement Analysis, 8th Edition

equivalent of equity capital. This is particularly true when the company can choose at
any time to force conversion of the debt by calling it in.

Instructor's Solutions Manual

8-7

EXERCISES
Exercise 8-1 (35 minutes)
a. First alternative:
Net income can be computed from:
Net income + ($1,000,000)(12%)(1-0.40) / ($4,000,000 + $2,000,000) = 10%
Net income = $528,000
Next, operating income is computed as:
Operating income = [$528,000/(1-0.40)] + ($1,000,000 12%)
Operating income = $1,000,000
Second alternative:
Net income can be computed from:
Net income + ($2,000,000)(12%)(1-0.40) / ($4,000,000 + $2,000,000) = 10%
Net income = $456,000
Next, operating income is computed as:
Operating income = [$456,000/(1-0.40)] + ($2,000,000 12%)
Operating income = $1,000,000
b. First alternative:
ROCE = $528,000 / $5,000,000 = 10.56%
Second alternative:
ROCE = $456,000 / $4,000,000 = 11.40%
c. First alternative:
Leverage = $6,000,000 / $5,000,000 = 1.2
Second alternative:
Leverage = $6,000,000 / $4,000,000 = 1.5
d. First, lets compute return on assets (ROA):
First alternative: $528,000 + ($1,000,000 x 12%)(1-0.40) / $6,000,000 = 10%
Second alternative: $456,000 + ($2,000,000 x 12%)(1-0.40) / $6,000,000 = 10%
Second, notice that the interest rate is 12% on the debt (bonds). More
importantly, the after-tax interest rate is 7.2% (12% x (1-0.40)), which is less
than ROA. Hence, the company earns more on its assets than it pays for debt
on an after-tax basis. That is, it can successfully trade on the equityuse
bondholders funds to earn additional profits.
Finally, since the second alternative uses more debt, as reflected in the
leverage ratio in c, the second alternative is probably preferred. The
shareholders would take on additional risk with the second alternative, but the
expected returns are greater as evidenced from computations in b.

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Financial Statement Analysis, 8th Edition

Exercise 8-2 (40 minutes)

a. Net income = $10,000,000 x 10% = $1,000,000
Operating income = [$1,000,000 / (1-0.40)] + $0 = $1,666,667
b. (Note: After expansion, total assets = $10,000,000 + $6,000,000 = $16,000,000)
First alternative:
Interest = $2,000,000 5% = $100,000
Hence, we can solve for net income as follows:
[Net income + $100,000(1-0.40)] / $16,000,000 = 10%
Net income = $1,540,000
Also, operating income would be:
Operating income = [$1,540,000 / (1-0.40)] + $100,000 = $2,666,667
Second alternative:
Interest = $6,000,000 6% = $360,000
Hence, we can solve for net income as follows:
[Net income + $360,000 (1-0.40)] / $16,000,000 = 10%
Net income = $1,384,000
Also, operating income would be:
Operating income = [$1,384,000 / (1-0.40)] + $360,000 = $2,666,667
c. First alternative: ROCE = $1,540,000 / ($10,000,000 + $4,000,000) = 11%
Second alternative: ROCE = $1,384,000 / ($10,000,000 + $0) = 13.84%
d. ROCE is higher under the second alternative due to successful use of
leveragethat is, successfully trading on the equity. [Note: Leverage is
1.14=$16 mil./$14 mil. (1.60=$16 mil./$10 mil.) under the first (second)
alternative.] The company should pursue the second alternative in the interest
of shareholders (assuming projected returns are consistent with current
performance levels).

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8-9

Exercise 8-3 (45 minutes)

a. ROCE
17.86%

= Adjusted profit margin x Asset turnover x Leverage

= 0.05 x 2 x 1.786

b. Total assets = Sales / Asset turnover

$2,500,000 = $5,000,000 / 2
Net income = $5,000,000 x 5% = $250,000
Capital Structure:
Current liabilities ($2,500,000 x 10%).............................
Long-term debt ($2,500,000 x 30%)................................
Minority interests (given).................................................
Total non-equity capital...................................................
Common equity ($2,500,000 - $1,100,000).....................

$ 250,000
750,000
100,000
$1,100,000
$1,400,000

Interest:
Current liabilities ($250,000 x x 5%)..........................
Long-term debt ($750,000 x 6%)....................................

$ 6,250
45,000
$51,250

ROA = [NI + Interest (1-Tax rate) + Minority interest in earnings] / Total

assets
= $250,000 + $51,250(1 - 0.40) + $1,000
$2,500,000
= 11.27%
c. Analysis of Leverage on Common Equity:
Funds
Source of funds
Supplied
Current liabilities ().......... $125,000
Current liabilities ().......... 125,000
Long-term debt.................... 750,000
Minority interests................ 100,000
(a)
(b)

Return
at 11.27%
$14,087.5
14,087.5
84,525.0
11,270.0

Payment
or Credit
to Funds
Suppliers
$
--3,750(a)
27,000(b)
1,000

Accruing
to
Common
$14,087.5
10,337.5
57,525.0
10,270.0
$92,220.0

($125,000)(5%)(1-0.40) = $ 3,750
($750,000)(6%)(1-0.40) = $27,000

Net leverage advantage to common equity = $92,220/$1,400,000 = 6.59%

Return on total assets
11.27%
Leverage advantage
6.59
Return on equity
17.86%

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Financial Statement Analysis, 8th Edition

Exercise 8-4 (30 minutes)

a. Computation and Interpretation of ROCE:
Year 5
0.112
0.46
3.25
0.570
9.54%

Year 9
0.109
0.44
3.40
0.556
9.07%

Pre-tax profit margin...........................................................

Asset turnover.....................................................................
Leverage...............................................................................
After-tax income retention *...............................................
ROCE (product of above)...................................................
* 1-Tax rate.
ROCE declines from Year 5 to Year 9 because: (1) pre-tax margin decreases by
approximately 3%, (2) asset turnover declines by roughly 2.25%, and (3) the
tax rate increases by about 2.5%. The combination of these factors drives the
decline in ROCEthis is despite the slight improvement in leverage.
b. The main reason EPS increases is that shareholders had a large amount of
assets and equity working for them. Namely, the company grew while return
on assets and return on equity remained fairly stable. In addition, the amount
of preferred stock declined, as did the amount of preferred dividends. With
this decline in the cost of carrying preferred stock, earnings available to
common stock increased.
(CFA Adapted)

Instructor's Solutions Manual

8-11

Exercise 8-5 (30 minutes)

a. ROCE
35.01%

= Adjusted profit margin x Asset turnover x Leverage

= 7% x 3 x 1.667

b. Total assets = Sales / Asset turnover = $12,000,000 / 3 = $4,000,000

Net income = $12,000,000 x 7% = $840,000
Capital Structure:
Current liabilities ($4,000,000 x 15%)...............................
Long-term debt ($4,000,000 x 20%)..................................
Common equity ($4,000,000 x 60%).................................
Minority interests (given)..................................................
Total assets.........................................................................

$ 600,000
800,000
2,400,000
200,000
$4,000,000

Interest:
Current liabilities ($600,000 x 1/3 x 4%)...........................
Long-term debt ($800,000 x 5%).......................................

$ 8,000
40,000
$48,000
ROA = [NI + Interest (1 - Tax rate) + Minority interest in earnings] / Total
assets
= [$840,000 + $48,000 (1 - 0.50) + $2,000] / $4,000,000
= 21.65%
c. Analysis of Leverage on Common Equity:
Funds
Source of funds
Supplied
Current liabilities (2/3)...... $400,000
Current liabilities (1/3)...... 200,000
Long-term debt.................. 800,000
Minority interests.............. 200,000

Payment
or Credit
Return
to Funds
at 21.65% Suppliers
$ 86,600
$
--43,300
4,000
173,200
20,000
43,300
2,000

Accruing
to
Common
$ 86,600
39,300
153,200
41,300
$320,400

Net leverage advantage to common equity = $320,400 / $2,400,000 = 13.35%

Return on assets........................................................... 21.65%
Leverage advantage..................................................... 13.35
Return on common equity (rounding difference)...... 35.00%

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Financial Statement Analysis, 8th Edition

Exercise 8-6 (30 minutes)

a. At the present level of debt, ROCE = $157,500 / $1,125,000 = 14%.
In the absence of leverage, the noncurrent liabilities would be substituted with
equity. Accordingly, there would be no interest expense with all-equity
financing. Consequently, in this case, net income would be as follows:
Net income (with leverage)...................................
$157,500
Plus interest saved ($675,000 8%).................... $54,000
Less tax effect of interest expense..................... 27,000
27,000
Net income (without leverage).............................
$184,500
ROCE without leverage = $184,500 / $1,800,000 = 10.25%.
This means that leverage is beneficial to Rose's shareholders since ROCE is
14% with leverage but only 10.25% without leverage.
b. Determination of Net Income with 20% ROA:
ROA
= [Net income + Interest (1 - Tax rate)] / Total assets
20%
= [Net income + ($675,000 x 8%)(1-0.50)] / $2,000,000
Net income
= $373,000
(This means that to achieve a 20% ROA, net income of $373,000 must be
earned.)
Determination of ROCE:
ROCE = $373,000 / $1,125,000 = 33.16%
Determination of Leverage:
Leverage = 33.16% / 20% = 1.66
c. Since the leverage ratio is substantially greater than 1, it indicates that a
substantial component of total financing is made up of debt financing.
Provided the company can successfully trade on the equity, then leverage is
beneficial to the shareholders.

Exercise 8-7 (18 minutes)

1. c
2.
b
3. a
4.
c

Instructor's Solutions Manual

8-13

Exercise 8-8 (20 minutes)

(Assessments of profit margin and asset turnover are relative to industry
norms.)
a. Higher profit margin and lower asset turnover.
b. Higher asset turnover and lower profit margin.
c. Higher profit margin and similar/lower asset turnover.
d. Higher asset turnover and similar/lower profit margin.
e. Higher asset turnover and lower/similar profit margin.
f. Higher asset turnover and similar/higher profit margin.
g. Higher asset turnover and lower profit margin.

Exercise 8-9 (20 minutes)

The memorandum to Reliable Auto Sales President would include the following
points:
Both Reliable and Legend Auto Sales are perpetually investing $100,000 in
automobile inventory.
Legend Auto Sales is able to generate more profit than Reliable because it is
turning over its inventory (10 cars) more often. Specifically, Legend is turning
its inventory over 10 times per year while Reliable is turning its inventory over
only 5 times per year. Hence, given the same investment in automobile
inventory, Legend is twice as profitable as Reliable.
Encourage Reliable to sacrifice some return on each sale to increase the
inventory turnover. By slightly reducing price, relative to that charged by
Legend, Reliable predictably will find that overall profitability increases. This
is because while profit per sale declines, the number of units sold and,
therefore, inventory turnover will increase. These factors predictably yield
increased return on assets.

Exercise 8-10 (20 minutes)

Computation of Asset (PP&E) Turnover [computed as Sales / PP&E (net)]:
Northern: $12,000 / $20,000 = 0.60
Southern: $6,000 / $20,000 = 0.30
This implies that Northern generates $0.60 in sales per year for each $1
investment in PP&E. In contrast, Southern generates $0.30 in sales per year for
each $1 investment in PP&E. This shows that Northern is able to generate twice
the return for each $1 invested in PP&E.
Assuming equal profit margins,
Northern will report a higher return on assets because of the volume of sales that
the company is able to generate with its investment in PP&E (at least in the short
run).

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Financial Statement Analysis, 8th Edition

PROBLEMS
Problem 8-1 (50 minutes)
a. 1. Quaker Oats does not reveal its computation of this return. Accordingly, we
make some simple computations and assumptions: (i) For simplicity, focus
on one share, (ii) The dividend is $1.56 [121] for Year 11, (iii) The average
stock price is $55 and the price increase for Year 11 is $14based on the
beginning price of $48 and the ending price of $62. Using this information,
we compute return to a share of stock as follows:
= [Dividend per share + Price increase per share] / Average price per share
= [$1.56 + $14] / $55
= 28.3%
However, if we use the beginning price of $48 per share, we get closer to
the company's 34% return:
= [$1.56 + $14] / $48
= 32.4%
2. The return on common equity is based on the relation between net income
and the book value of the equity capital. In contrast, Quaker Oats return
to shareholders uses dividends plus market value change in relation to
the market price per share (cost of investment to shareholders.)
3. These two concepts are similar but not identical in computation. The return
on shareholder's investment (ROSI) focuses on the dividend plus the
market's valuation on earnings retained. Quaker Oats return to
shareholders focuses on dividends plus change in the market value of the
stock. However, in both cases, the earnings (numerator) are measured in
relation to shareholder's cost of investment (instead of the book value of
equity as with ROCE).
4. Quaker Oats Year 11 ROCE is computed as follows:
Net income [11] - Preferred dividends [12]
Average common equity [91]
= [$205.8 - $4.3] / [($901.0 + $1,017.5)/2] = 21.01%
Notice that the ROCE disclosed in its annual report (24.1%) is higher. It is
possible that Quaker Oats figure ignores the effect of discontinued
operations. If we ignore the effect of discontinued operations, then ROCE
is:
= $235.8 / [($901.0 + $1,017.5 + $30)/2] = 24.2%
b. The company must have derived the 3.6% from price, market, and other
factors that are not disclosed. Conceptually, this 3.6% should reflect the
added risk of an investment in Quaker Oats stock vis--vis a risk-free security
such as a U.S. Treasury bond.
c. Quaker does not reveal its computations. It discloses a variety of interest
rates on long-term debt [148] that it carries. Based on data available to it, but
not to the financial statement reader, it probably computed a weighted-

Instructor's Solutions Manual

8-15

average interest rate from which it deducted the tax benefit in arriving at the
6.4% cost of debt.

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Financial Statement Analysis, 8th Edition

Problem 8-2 (75 minutes)

a. 1. NI [28] + Interest expense [18] x (1 Tax rate) + Minority int. in earnings [25]
Average total assets ([39A] + [185A]) / 2
= [$4.4 + $111.6 (1-0.34) + $5.7] / [($4,115.6 + $3,932.1)/2] = 2.08%
2. Net income - Preferred stock dividends
Average common equity*
=[$4.4-$0]/ {[$1,691.8 [185] +( x $235.1 [176]) + $1,778.3 [185] +( x $218)]/
2}
= 0.24%
* Excludes minority interest and includes 50% of deferred taxes

3. NI + Interest expense x (1 Tax rate) + Minority interest in earnings

Average of long-term liabilities and equity
= [$4.4 + $111.6 (1 0.34) + $5.7] / [($2817.5** + $2,700**)/ 2]
= 3.04%
Long-term debt [185]..................................
Other liability [177]......................................
50% deferred income taxes [176]...............
Total long-term debt....................................

4.

Year 10
805.80
28.50
117.55
951.85

Year 9
629.20
19.60
109.00
757.80

Shareholders' equity [185].........................

50% deferred income taxes [176]...............
Long-term debt [185]..................................
Total equity..................................................

1,691.80
117.55
56.30
1,865.65

1,778.30
109.00
54.90
1,942.20

**Total long-term debt and equity..............

2,817.50

2,700.00

Total Assets
.
Total Stockholders Equity
= 4,115.6/1,691.8 = 2.43

5. Net income [28] - dividends [87A]

Average common equity
= ($4.4 - $126.9) / $1,848.3 = - 6.63%

Instructor's Solutions Manual

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Problem 8-2continued
b. ROCE

= Adjusted profit margin x Asset turnover x Leverage

= ($4.4/$6,205.8) x ($6,205.8/$4,023.9) x ($4,023.9/$1,848.3)
= 0.07% x 1.54 x 2.18
= 0.24%

Components of ROCE indicate that profit margin is especially low. While profit
margin is expected to be low for a company such as Campbell, this seems
lower than expected for the industry. Since leverage is greater than one, it
contributes to enhancing ROCE. To fully evaluate ROCE we would want
comparisons with prior year returns as well as with industry norms over the
same period of time.
c. Asset Turnover Computations:
Ratio

Numerator

Sales to cash & equivalents......

Sales to receivables...................
Sales to inventories....................
Sales to working capital.............
Sales to fixed assets..................
Sales to other assets..................
Sales to total assets...................

$6,205.8 [13]
6,205.8
6,205.8
6,205.8
6,205.8
6,205.8
6,205.8

Denominator
$ 103.2 [31]+[32]
624.5 [33]
819.8 [34]
367.4 [36]-[45]
1,717.7 [37]
349.0 [39]
4,115.6 [39A]

Turnover
60.1
9.9
7.6
16.9
3.6
17.8
1.5

d. Campbell's return on common equity is 0.24%. This return is markedly lower

than the comparable company's 12.7% return. Consequently, on this
information alone we would pick the other company. However, one limitation
in this comparison is that the returns are based on book values of equity.
Instead, the return earned by an investment in a company for an individual
stockholder is based on the cost of his/her shares. In the latter case, the
market price per share is relevant to this decision, as are other factors such as
yield, price-earnings ratios, and so forth.

8-18

Financial Statement Analysis, 8th Edition

Problem 8-3 (50 minutes)

a. Computation of Return on Invested Capital Measures:
As a first step, we construct the companys income statement.
Sales (500,000 units @ $10)................................................
Fixed costs......................................................................
Variable costs (500,000 units @ $4)..............................
Labor costs (20 employees x $35,000).........................
Income before taxes.........................................................
Taxes (50% rate)................................................................
Net income........................................................................

$5,000,000
1,500,000
2,000,000
700,000
$ 800,000
400,000
$ 400,000

(1) [$400,000 + ($2,000,000 x 7.5%)(1-0.50)] / $8,000,000 = 5.94%

(2) [$400,000 - ($1,000,000 x 6%)] / $3,000,000 = 11.33%
b. Wage Rate Analysis to meet a Target Return on Invested Capital:
Estimated Fiscal Year 9 Operations:
Sales (550,000 units @ $10)..............................................................$5,500,000
Fixed costs ($1,500,000 x 1.06)..........................................................1,590,000
Variable costs ($550,000 units @ $4)............................................... 2,200,000
Income before labor costs and taxes..............................................$1,710,000
To obtain a 10% return on long-term debt and equity capital, Zear will need a
numerator of $600,000 given an invested capital base of $6,000,000. The
required net income to yield this $600,000 amount is computed as:
Net income + Interest expense x (1 - 0.50) = $600,000
Net income + ($2,000,000 x 7.5%) x (1-0.50) = $600,000
Net income = $525,000
Assuming taxes at a 50% rate, Zear needs pre-tax income of $1,050,000,
computed as:
Income before labor and taxes.............$1,710,000
Labor costs............................................
?
Pre-tax income.......................................$1,050,000
This implies:
Labor costs = $660,000 or
Average wage per worker = $660,000 / 22 employees = $30,000 per employee
Since the current salary level is $35,000, Zear cannot achieve its target return
level and give a salary raise to its employees.
(CFA Adapted)

Instructor's Solutions Manual

8-19

Problem 8-4 (60 minutes)

a. Year 9 Computations of the Five Components of ROCE:
Profit margin = ($2,550 + $10) / $7,120 = .360
Asset turnover = $7,120 / $7,250 = .982
Interest burden = $2,550 / ($2,550 + $10) = .996
Leverage = $7,250 / $3,860 = 1.878
Retention = $1,650 / $2,550 = .647
b. ROCE = .360 x .982 x .996 x 1.878 x .647 = 42.8%
c. Comparison and Interpretation of ROCE between Year 9 and Year 4:

Profit margin ....................................

Asset turnover .................................
Interest burden ................................
Leverage ..........................................
Retention ..........................................
ROCE ................................................

Year 4
.245
.724
.989
1.877
.628
20.7%

Year 9
.360
.982
.996
1.878
.647
42.8%

Impact on
change in ROCE

Very favorable
Very favorable
Favorable
Unchanged
Favorable
Very favorable

The ROCE for Merck more than doubled in Year 9 compared to Year 4 (from
20.7% to 42.8%). The two primary factors behind this improvement were an
increase in profit margin and an increase in the asset turnover. Regarding the
profit margin, Merck was able to increase selling prices or reduce operating
costs, or some combination of both. Regarding the higher asset turnover, this
improvement is indicative of greater efficiency because Merck was able to
produce more sales revenue per dollar of assets. Also, the increase in the
retention rate means a lower tax rate, and an increase in the interest burden
means interest is a smaller percentage of pretax income. Both of these items
had a small, but favorable, impact on ROE.

8-20

Financial Statement Analysis, 8th Edition

Problem 8-5 (75 minutes)

a. 1. Net income + Interest expense (1 - Tax rate) + Minority interest in earnings
(Beginning total assets + Ending total assets) / 2
Year 5 :

$7,000 $6,000 (1 - 0.5) $0

10.03%
($94,500 $105,000) / 2

Year 6 :

$10,000 $10,000 (1 - 0.5) $200

12.51%
($105,000 $138,000) / 2

2. Net income - Preferred dividends

Average common equity
Year 5:

($7,000 $0) / [($42,000 + $47,000)/ 2] = 15.73%

Year 6:

($10,000 $0) /[($47,000 + $54,000)/2] = 19.80%

3. Net income - Preferred dividends - Common dividends

Average common equity
Year 5:

($7,000 - $2,000) / [($42,000 + $47,000)/ 2]= 11.24%

Year 6:

[$10,000 - $3,000]/[($47,000 + $54,000)/ 2]= 13.86%

b. Each of the return on investment measures for ZETA improved from Year 5 to
Year 6. The return on common equity increased 25% and the increases for the
other return measures are equally impressive. Also, the increase in the equity
growth rate, a measure of the company's ability to finance further expansion
through internally generated funds, seems to be mainly due to the increase in
profit margin, which is a healthy sign.

Instructor's Solutions Manual

8-21

Problem 8-5continued
c. ROCE

= Adjusted profit margin x Asset turnover x Leverage

Year 5:

($7,000/$155,000) x ($155,000/$99,750) x ($99,750/$44,500)

= 0.0452 x 1.554 x 2.242
= 15.75%

Year 6:

($10,000/$186,000) x ($186,000/$121,500) x ($121,500/$50,500)

= 0.0538 x 1.531 x 2.406
= 19.82%

Comments on the disaggregated ROCE:

By disaggregating ROCE, the analyst can evaluate the factors that determine
the ratio. The adjusted profit margin represents the portion of each sales
dollar that is left for the common shareholder after providing for all costs. This
margin markedly increased for Zeta. The asset turnover measures the
utilization of assets, that is, how many dollars of sales are generated by each
dollar of assets. The turnover slightly declined for Zeta. The leverage ratio
measures how many dollars of assets are financed by dollars of equity
invested. The leverage of Zeta increased, yielding more opportunities to
successfully (or unsuccessfully) trade on the equity. In sum, Zeta's ROCE
increased substantially in Year 6 due to an increase in profit margin (net
income to sales) as well as an increase in leverage.
d. Analysis of Leverage on Common Equity:
(Note: From part a, we know ROA = 12.5%)
Average
return
Category of
Funds
common
Fund Supplier
Supplied
Current liabilities....................... $45,500
Long-term debt.......................... 21,600
Deferred taxes...........................
2,800
Minority interest........................
1,100
Earnings in excess of return
to suppliers of funds...............
Add common equity.................. $50,500
Total return to shareholders.....

Earnings
on funds
supplied

Payment

Accruing to
(detracting
from)

at rate

to supplier

on

of 12.5%
$5,688
2,700
350
138

of funds
$3,000a
2,000b
0
200

$6,313

stock
$2,688
700
350
(62)
$3,676
6,313
9,989c

Interest cost of $6,000 less 50% tax.

Interest cost of $4,000 less 50% tax.
c
The difference of $11 between the statement figure and $10,000 is due to rounding.
a

Analysis of the composition of return on common equity focuses on the

contribution of each fund category to the return realized by common equity.
Current liabilities, because they are largely interest free, are the largest
contributors. So are deferred taxes, but they are much smaller in size. While the

8-22

Financial Statement Analysis, 8th Edition

computation considers the minority interest, its share does not represent a
"payment" to suppliers of funds.

Instructor's Solutions Manual

8-23

Problem 8-6 (75 minutes)

a. Computations for ROCE Components:
Year 5
Profit margin.............................($38-$3)/ $542 = 6.46%
Asset turnover..........................
$542/$245 = 2.21
Interest burden.........................
$3/$245 = 1.22%
Leverage...................................
$245/$159 = 1.54
Effective tax rate......................
$13/$32 = 40.63%

Year 9
($76-$9)/ $979= 6.84%
$979/$291 = 3.36
$291/$220 = 1.32
$37/$67 = 55.22%

b. ROCE = [(Profit margin x Asset turnover)- Interest burden] x Leverage x (1-Tax

Rate)
Year 5: [(6.46% x 2.21) - 1.22%] x 1.54 x .5937 = 11.94%
Year 9: [(6.48% x 3.36) - 0.00%] x 1.32 x .4478 = 12.87%
c. Asset turnover measures the ability of a company to efficiently utilize its
assets (current and noncurrent) to generate sales. The asset turnover
increased substantially over the period Year 5 to Year 9. This largely
contributed to a substantial increase in ROCE. Leverage measures the extent
of non-equity financing, including both short- and long-term debt. Leverage
declined over the period Year 5 to Year 9, adversely affecting ROCE because
Texas Telecom was successfully trading on its equity. Since asset turnover
rose substantially more than leverage declined, the net effect was an increase
in ROCE.

8-24

Financial Statement Analysis, 8th Edition

CASES
Case 8-1 (120 minutes)
a. Computation of Return on Invested Capital Measures:
Year 11
(1) Return on total assets [a]............................. 8.61%
(2) Disaggregated ROA:
Profit margin [a]........................................ 4.97%
Asset turnover [a]..................................... 1.73
(3) Return on common equity [b]...................... 21.01%
(4) Equity growth rate [c].................................... 8.63%
(5) Disaggregated ROCE [d]:
Adjusted profit margin............................. 3.67%
Asset turnover.......................................... 1.73
Leverage.................................................... 3.31

Year 10
7.70%
4.94%
1.56
15.27%
5.35%
3.27%
1.56
2.99

Computation notes:
[a] Net income [11] + Interest expense [156] (1 Tax rate) [158]
Average total assets [69]
11: [$205.8+$101.9 (1-.34)] / [($3,016.1+$3,326.1)/2] = 8.61%
10: [$169.0+$120.2 (1-.34)] / [($3,326.1+$3,125.9)/2] = 7.7%
Disaggregated:
11 profit margin: $273.1 / $5491.2 = 4.97%
11 asset turnover: $5,491.2 / $3,171.1 = 1.73
10 profit margin: $248.3 / $5,030.6 = 4.94%
10 asset turnover: $5,030.6 / $3,226.0 = 1.56
[b] Net income [11] - Preferred dividends [12]
Average common equity [91]
11: [$205.8 - $4.3] / [($901.0 + $1,017.5)/2] = 21.01%
10: [$169.0 - $4.5] / [($1,017.5 + $1,137.1)/2] = 15.27%
[c] Net income [11] - Total dividends paid [12, 121]
Average common equity ([c] above)
11: [$205.8 - $118.7 - $4.3] / $959.3 = 8.63%
10: [$169.0 - $106.9 - $4.5] / $1,077.3 = 5.35%

Instructor's Solutions Manual

8-25

Case 8-1continued
[d]

Net income [11] - Preferred dividends [12]

Sales [1]

Sales [1]
Average total assets ([a] above)

Average total assets ([a] above)

Average common equity ([c] above)

11 :

$205.8 - $4.3
$5,491.2 $3,171.1

$5,491.2
$3,171.1
$959.3

= 3.67% x 1.73 x 3.31 = 21.01%

10 :

$169.0 - $4.5
$5,030.6
$3,226.0

$5,030.6
$3,226.0
$1,077.3

= 3.27% x 1.56 x 2.995 = 15.27%

b. Computation of Asset Turnover Ratios:

(1)
(2)
(3)
(4)
(5)
(6)

Sales to cash............................................................
Sales to receivables.................................................
Sales to inventories.................................................
Sales to PP&E, net...................................................
Sales to other assets...............................................
Sales to total assets................................................

Year 11
181.83
7.95
13.00
4.45
47.96
1.82

Year 10
284.21
7.99
10.62
4.36
47.01
1.51

c. Quaker Oats has improved its return on assets and its return on common equity.
This year-to-year change analysis reveals increases in most of its components.
Also, many of the improvements are substantial. Specifically, ROCE increased by
38% primarily due to the increase in net income and a small reduction in equity.
This is borne out by the disaggregated ROCE where the profitability ratio showed
marked improvement. Asset turnover and leverage ratios also contributed to this
year-to-year improvement. Also, the equity growth rate measures a company's
ability to expand through the use of internally generated and retained funds. For
Quaker Oats, the equity growth rate increased 59%. This is mainly due to its
increased profitability.

8-26

Financial Statement Analysis, 8th Edition

Case 8-1continued
d. Analysis of Leverage on Common Equity ($ mil.):
Average
Earnings
Payment
Accruing to
Funds
on Funds
to supplier
(Detracting
Funds Suppliers
Supplied
of 8.61%
of funds
from)
Current liabilities..................... $1,032.7
$88.9
$39.9A
$ 49.0
Long-term debt .....................
720.75
62.1
27.4B
34.7
Other liabilities........................
107.9
9.3
-9.3
Deferred taxes.........................
347.2
29.9
-29.9
Preferred stock........................
3.3
0.3
4.3B
(4.0)
Common equity.......................
959.25
82.6
-82.6
$3,171.10
$273.1
$71.6
Total return to common equity......................................................................... $201.5
A
B

Interest on short-term debt and Other [156], $60.5 x(1 - .34) = $39.9.
The balance = $27.4.

Current liabilities (many interest free) and deferred taxes (interest free)
contributed significantly to common stockholder's return. Preferred stock,
however, slightly reduced this return.
e. (1) Average gross productive assets = Total assets [69] - Intangible assets [67]
- Net assets of discontinued operations [61 + 68] + Accumulated depreciation
[65] - 20% of Total other current assets [60]
($3,016.1+$3,326.1)-($446.2+$466.7)-($160.5+$252.2)+($681.9+$591.5)-(.20)($114.5+
$107.0)
2

= $3,122.85
Net income [11] + Interest expense [156] (1 Tax rate)
Average gross productive assets
= [$205.8 + $101.9 (1 - .34)] / $3,122.85 = 8.74%
(2)

Net income [11] - Preferred dividend [12]

Common shares outstanding [85 - 90] x Market price per share [137]
= [$205,800,000 - $4,300,000] / [76,328,721 x $53.0625*] = 4.98%
* Market price per share = ($64.875 + $41.25)/ 2 = $53.0625.

Instructor's Solutions Manual

8-27

Case 8-2 (75 minutes)

a. ROCE formula is:
EBIT
Revenues

Revenues
Total Assets

Interest
Assets
x (1 - Tax rate)
Total Assets
Common Equity

Calculations:
Thompson:[(.322 x 0.61) - 0.019] x 1.53 x (1 - 0.28) = 19.5%
Southam: [(.073 x 1.29) - 0.027] x 2.39 x (1 - 0.43) =

9.2%

b.
EBIT/Sales
Interest
Turnover

Thomson

Southam

Lower than in its early years, but

trending up recently. Rising margin
supports higher ROCE.
Increase in early years but declined
dramatically up to Year 11. Lower
burden leads to higher ROCE.

Much lower than in its early

years. Flat trend recently. Lower
margin leads to lower ROCE.
Steady increase over period,
peaking in Year 4 but with recent
decline. Higher interest burden
reduces ROCE.
Increased steadily through Year 6.
Fallen since, except in last two
years. Rising tax reduces ROCE.
Steadily declining ratio. Declining
ratio leads to a lower ROCE.

Tax Rate

Steady decline. Lower tax rate leads

to higher ROE.

Asset
Turnover

Improves until Year 5.

Fluctuating recently. Rising turnover
leads to higher ROCE.
Aggressive expansion led to rising
leverage. However, ratio has
declined to earlier levels. Increased
leverage can yield higher ROCE.

Leverage

8-28

Ratio increased dramatically

through Year 7, but declined
recently. Increased leverage has
been a source of rising ROCE for
Southam.

Financial Statement Analysis, 8th Edition

Case 8-3 (95 minutes)

a.

2001

1. Return on Assets:
[76+219-(219x.34)]
[(13,362+14,212)/2]
(76+219-74)
13,787
1.60%
2.

[1,407+178-(178x.34)]
[(14,212+14,370)/2]
(1,407+178-61)
14,291
10.66%

Disaggregated ROA Computations:

Profit Margin:
(76+219-(219x.34)
13,234
1.66%
Asset Turnover:
13,234/13,787
0.960
Profit Margin x Asset Turnover:
1.60%

3.

2000

Return on Common Equity:

(76-0)
3,161
2.40%

4. Equity Growth Rate:

(76-0-643)
3,161
N/A

Instructor's Solutions Manual

(1,407+178-(178x.34))
13,994
10.89%
13,994/14,291
0.979
10.66%

(1,407-0)
3,670
38.34%

(1,407-0-545)
3,670
23.49%

8-29

Case 8-3continued
a.
2001

2000

5. Disaggregated Return on Common Equity:

Adjusted Profit Margin:
(76-0)
13,234
0.574%

(1407-0)
13,994
10.054%

Asset Turnover:
0.960

0.979%

Leverage:

ROE

b.

13,787
3,161

14,291
3,670

4.362

3.894

2.40%

38.34%

2001

2000

1. Sales to cash
13,234
[(448+246)/2]

13,994
not enough information

38.14
2. Sales to Receivables
13,234
[(2337+2653)/2]

13,994
not enough information

5.30
3. Sales to Inventories
13,234
[(1,137+1,718)/2]

13,994
not enough information

9.27
4. Sales to property, plant, and equipment (Sales/Average PP&E)
13,234
13,994

8-30

Financial Statement Analysis, 8th Edition

[(5,659+5,919)/2]
2.29

Instructor's Solutions Manual

[(5,919+5,947)/2]
2.36

8-31

Case 8-3continued
b.

2001

5. Sales to other current assets

13,234
[(240+299)/2]

2000
13,994
not enough information

49.11
6. Sales to total assets
13,234
[(13,362+14,212)/2]
0.960

13,994
[(14,212+14,370)/2]
0.979

c. Kodak has generally provided shareholders with a good return on invested

capital. The year 2001 appears somewhat anomalistic. The return on assets in
2000 and 1999 was 10.66% and 9.57%, respectively. Similarly, the return on
common equity in those years was a robust 38.34% and 35.24%. These
relatively solid performances are driven by Kodaks profit margin of around
10% and its ability to leverage its debt. Its asset turnover is near 1, which is
similar or slightly lower than the industry norm.

8-32

Financial Statement Analysis, 8th Edition

Case 8-4 (75 minutes)

a. Computation and Disaggregation of ROCE:
Return on common equity

Year 9
$703/$3,044=.231

Year 13
$671/$5,030 = .133

Adjusted profit margin:

(Return on sales)

$703/$4,594=.153

$671/$8,529=.079

Asset turnover:
(Sales / Average assets) 1
$8,529/$11,751=.726
Leverage:
(Average assets/Average equity)

$4,594/$6,657=.690

$6,657/$3,044=2.187

$11,751/$5,030=2.34
1

Ending assets are used because information is unavailable to compute average assets.

b. Disneys profit margin on sales decreased substantially from Year 9 to Year 13.
Some reasons for this change include:

Disney experienced above average growth in the film entertainment

business, which has the lowest operating margin of any of its business
segments.
Disney experienced deterioration in consumer product margins as the
business mix shifted away from licensing and royalty income.
Euro Disney losses and reserve provision (write-off) hurt Year 13 results, as
compared with no effect in Year 9.
Disney experienced deterioration in the theme park margins because of
lower attendancethis, in turn, stemmed from a slower economy and more
expensive admission prices.

Instructor's Solutions Manual

8-33