The Effect on ROI and Profits

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Dr. David Bennett
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Newcastle subtitle
Business Schoolstyle

03/10/2017 1
 Where does value come from?
Shareholder value can be main objective of
businesses

Value created when shareholder gets better

value on return than comparable investment
 Two common ways of measuring
shareholder value are:-
Return on Investment (ROI)

Economic value added (EVA)

 Return on Investment (ROI)
ROI is measured in profit () before interest
and tax as a percentage of capital employed %
ROI = 100 x profit / capital employed
The term investment is used because capital
employed is equivalent to the money invested
in the business
ROI can also be seen as the outcome of
profitability and asset utilisation
 ROI

ROI = Profit x Sales

Sales Capital Employed

Consider the detail behind the above ratios

and see how they fit together
 Sales
Superior customer service improves sales and
makes the company more valued to the
customer in the long term

Improving customer responsiveness is the key

for managing the supply chain
Costs
Sales
Minus
Revenue

Costs Profit

Plus
Inventory Divide Return
on capital
Cash and Employed
Debtors Capital
Minus Employed
Creditors
Plus

Fixed
Assets
 Working Capital
Combination of:-
Inventory
Cash and debtors
Less
Creditors
Is called working capital
Each of the elements of working capital is considered in
turn
 Inventory
An asset in many businesses
Can buffer uncertainty in demand
Permit immediate availability when replenishment
times are lengthy
However inventory often regarded as a hindrance:-
- It ties up cash
- It needs resources to be stored
- It goes obsolete
 Cash and Debtors

Make time between receipt and order and

receipt of cash as short as possible

Make organisations more competitive by

reducing lead time
 Debtors (Customers who owe us money)
Can be minimised by basic controls such as
regular review and problem resolution

Ensure invoices are complete before they are

sent out

Consider self billing (electronic means)

 Creditors (people/suppliers we owe money to)
In SCM this applies mainly to suppliers
Plan material requirements and distribution
requirements to minimise flow of parts through the
supply chain as needed
Discipline goods inwards to check delivery date,
quality and correct details (some organisations bar
scan and have self billing at this stage)
Negotiate payment times with suppliers if not self
billing
 Economic Value Added
ROI does not provide the complete picture
Does not compare the ROI with investors
required return
The required rate of return will depend on the
perceived risk of the investment
Also consider the opportunity cost of the
capital for the investor
 ROI
ROI describes the gross return on investment
not the amount of risk incurred
ROI is not a significant measure of whether an
organisation is creating value for its
shareholders
Value is created if the ROI more than
compensates for the additional risk
 Economic Value Added (EVA)
EVA is a measure of the ROI less the true cost
of capital employed to the investor

EVA = ROI true cost of capital employed

EVA measures return on capital employed less

the cost of financing that capital employed
 EVA
If EVA is positive, value is added to the
business

If EVA is negative, value is being drained out of

the business

The use of EVA encourages managers to

generate revenue