Analyzing and Improving

Management Performance
CHAPTER 4

Return on Investment

Return on Investment
evaluating how efficiently management employs the
average peso investment in an enterprises assets

disadvantage: tells only how well a business enterprise

utilized its assets and how it fared compared to others on its
industry

Du Pont Formula

Du Pont Formula (ROI breakdown)

ROI can be broken down into two factors profit margin and
asset turnover

Du Pont Formula (ROI breakdown)

advantages:
it recognizes the importance of turnover as a key to overall return on
investment
it recognizes the importance of sales
it stresses the possibility of trading margin for turnover in an attempt
to improve the overall performance of a business enterprise

Profit Improvement through

Du Pont Formula

Profit Improvement
the breakdown of ROI gives management insight into
planning for profit improvement
management can the take various actions to enhance ROI:
improve margin
improve turnover
improve both

Improving Margin
may be accomplished by reducing expenses, raising selling
prices, or increasing faster than expense
expenses may be reduced by:
using less costly materials
automating processes as much as possible to increase labor
productivity
bringing discretionary fixed costs under scrutiny and curtailing or
eliminating various programs

Improving Turnover
may be attained by increasing sales while holding
investment in assets relatively constant or by reducing
assets
some strategies to educe assets:
disposing of redundant and obsolete inventory
devising methods to speed up the collection of receivables and to
evaluate credit terms and policies
identifying unused plant assets
using the cash obtained by implementing the previous methods to
repay outstanding debts, repurchase outstanding issues of share
capital, or invest in other profit-producing activities

Improving Turnover
may be attained by increasing sales while holding
investment in assets relatively constant or by reducing
assets
some strategies to educe assets:
disposing of redundant and obsolete inventory
devising methods to speed up the collection of receivables and to
evaluate credit terms and policies
identifying unused plant assets
using the cash obtained by implementing the previous methods to
repay outstanding debts, repurchase outstanding issues of share
capital, or invest in other profit-producing activities

Example
Assume that total assets = P100,000, net profit after taxes =
P18,000,
sales = P200,000
20% ROI = profit target

Example
Alternative 1
Increase the margin while holding turnover constant
Reduce expenses by 2,000

Example
Alternative 2
Increase turnover by reducing investment in assets while holding net
profit and sales constant
Reduce working capital or sell some land, reducing investment in
assets by 10,000 without affecting sales and net income

Improving Return to
Shareholders through
Financial Leverage

Modified Du Pont Formula

ties together the business enterprises ROI and its degree of
financial leverage, that is, the use of borrowed funds

Example
Kapuso Company and Kabayan Company, generate P300,000
in operating income. The comparative capital structures are:
Kapuso

Kabayan

P
800,000

P
800,000

400,000

Shareholders Equity (a)

800,000

400,000

Total liabilities and Shareholders

equity

P
800,000

P
800,000

Total assets
Total liabilities

Example
Kabayan pays 10% interest for borrowed funds. The
comparative income statements and ROEs are as follows:
Kabayan

Kapuso

P
300,000

P
300,000

(40,000)

Profit before taxes

P
300,000

P
260,000

Taxes (30%
assumed)

(90,000)

(78,000)

Net profit after taxes

(b)

P
210,000

P
182,000

ROE [(a)(b)]

26.25%

45.5%

Operating Income
Interest Expense

Example
Although the absence of debt allows Kapuso to register higher
profits after taxes, the owners of Kabayan enjoy a significantly
higher return on their investments. This contrast
demonstrates the benefits that accrue from using debt up to
a limit. Too much debt can increase a business enterprises
financial risk and thus its cost of financing.

The Sustainable Rate of

Growth

The Sustainable Rate of Growth

represents the rate at which a business enterprises sales
can grow if it wants to maintain its present financial ratios

The Sustainable Rate of Growth

For this equation to accurately depict a business enterprises
sustainable rate of growth, the following assumptions must
hold:
1) The business assets must vary as a constant percent of
sales.
2) Business enterprises liabilities must all vary directly with
firm sales.
3) The business enterprise pays out a constant proportion of
its earnings in ordinary share capital dividends regardless
of the level of business sales.

Economic Value Added (EVA)

Economic Value Added (EVA)

a measure of an operations true profitability

Economic Value Added (EVA)

an estimate of a business true economic profit for the year
represents the residual income that remains after the cost of
all capital has been deducted
provides a good measure of whether the firm has added to
shareholder value
provides a useful basis for determining managerial
compensation