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Ratio Analysis. Return on Invested Capital

We have some basic formulas for the "Return on Invested Capital" exam section:

              NI
ROI = ---------- - Return on invested capital (Return on investment) or Return on
            ATA                  total assets

Invested capital may be defined in various ways: Total Assets, Long-Term Debt plus Total Equity, Total Equity and the others. But for exam purposes term "invested capital" (without additions) means Average total assets.

Note: When the Balance Sheet component (Total Assets) and the Income Statement component (Net Income) meet in the same ratio, then the Balance Sheet amount should be an average for the period.
ATA = (TA1 + TA2)/2
Where TA1 - beginning Total Assets,
         TA2 - ending Total Assets.

               NI - PrefDiv
ROE = ----------------------- - Return on Common Equity
               ACommEquity

You will meet several questions about interrelations between ROI, ROE and the other ratios.

We need following ratios:

Profit Margin = NI / NetSales
Adjusted Profit Margin = (NI - PrefDiv) / NetSales

TAssetsTurnover = NetSales / ATA - Total Assets Turnover ratio

FLR = ATA / ACommEquity - Financial Leverage ratio also called Equity Multiplier (leverage factor)


and Du Pont equation is:

DuPontEquation.gif

= TAssetsTurnover * Profit Margin





Therefore, Return on invested capital is equal Total Assets Turnover times Profit Margin.

If we multiply equation above by Equity Multiplier (Financial Leverage ratio or leverage factor) and will use Adjusted Profit Margin instead Profit Margin then we will receive following relation:
ROEFormula.gif

ROE = TAssetsTurnover * AdjustedProfitMargin * Leverage factor

In addition, you should expect several questions about Sustainable Equity Growth rate and Dividend Payout ratio (DivPayout):

DivPayout = Dividends per common share / EPS

Sustainable Equity Growth = ROE * (1 - DivPayout)

List of notations

Posted by mazoo at May 3, 2005 9:13 PM

Related posts:

Ratio Analysis. Short-term liquidity. Part 2. Jun 24, 2005
Ratio Analysis. Short-term liquidity. Part 1. May 27, 2005
Ratio Analysis. Introduction. Apr 27, 2005

Comments

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Posted by: caroline at May 9, 2005 12:46 PM

Thank you, Caroline! I appreciate your kind words.

Posted by: Mazoo at May 10, 2005 7:51 PM