What is the return on investment equation?
Profit / capital employed
How do you work out capital employed?
Total equity plus non current liabilities
What are the advantages of return on investment?
Simple to calaculate and understand
Allows comparison between divisions of different sizes
Measures efficiency of capital employed
What are the drawbacks of return on investments?
Can lead to under investment
Encourages short term decision making
May discourage managers from accepting profitable investments
Include by accounting policies
How do you work out residual income?
Profit - ( capital employed x cost of capital)
What are the advantages of residual income?
Promotes goal congruence
Considers the cost of capital
Encourages managers to accept projects above the cost of capital to maximise shareholder wealth
What are the drawbacks of residual income?
More complex than ROI
Depends on an accurate cost of capital
Absolute measure making comparison between divisions difficult
How do you work out profit margin?
Profit / sales x 100
How do you work out turnover?
Sales / capital employed
How do you work out return on capital employed?
Profit before interest and taxation / equity + non current liabilities x 100%
What does a low return on capital employed mean?
Caused by a low profit margin or a low asset turnover or both.
How do you work out asset turnover?
Revenue / equity + non current liabilities
How do you work out gross profit margin?
Gross profit / revenue x 100
How do you work out gross profit margin?
Gross profit / revenue x 100
What does a low asset turnover indicate?
This indicates the company is not generating enough volume for the size of the asset base, so sales would need to be increased or assets disposed.
What does a low gross profit margin indicate?
This indicates selling prices too low or cost of sales too high.
How do you work out receivables collection period?
Trade receivables/ sales x 365 days
How do you work out payables payment period?
Trade payables / credit purchases x 365 days
How do you work out inventory holding period?
Inventory / cost of sales x 365 days
What is on a balanced performance score card?
Financial perspective
Customer perspective
Internal business process perspective
Innovation and learning perspecitve
What does a high ROI show?
Capital is being used efficiently
Good cost control or pricing
Strong operational performance
May show assets may be old and fully depreciated
May indicate under investment
What does a low ROI show?
Inefficient use of capital
Poor cost control or low margins
Possible over investment
What does a high RI show?
Division is generating profit above the cost of capital
Adds value to organisation
Strong contribution to overall performance
What does a low RI show?
Profit does not cover cost of capital
Division is destroying value
Indicates poor investment decisions or inefficiency
