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RETURN ON INVESTMENT
Return on Investment - Concept
The two complementary approaches to return on investment are:
•
Return on total assets (ROTA)
•
Return on equity (ROE)The two separate measures are necessary because they throw light on different aspects of the business, bothof which are important. Return on total assets looks at the operating efficiency of the total enterprise, whilereturn on equity considers how that operating efficiency is translated into benefit to the owners.RETURN ON EQUITY (ROE)This ratio is arguably the most important in business finance. It measures the absolute return delivered to theshareholders. A good figure brings success to the business – it results in a high share price and makes it easyto attract new funds. These will enable the company to grow, given suitable market conditions, and this inturn leads to greater profits and so on. All this leads to high value and continued growth in the wealth of itsowners.ROE = PAT x 100Owner’s fundsAt the level of individual business, a good return on equity will keep in lace the financial framework for athriving, growing enterprise. At the level of the total economy, return on equity drives industrial investment,growth in gross national product, employment, government tax receipts and so on.It is, therefore, a critical feature of the overall modern market economy as well as of individual companies.RETURN ON TOTAL ASSETS (ROTA)Return on total assets provides the foundation necessary for a company to deliver a good return on equity. Acompany without a good ROTA finds it almost impossible to generate a satisfactory ROE.ROTA = PBITx 100Total AssetsPBIT is the amount remaining when total operating cost is deducted from total revenue, but before either interest or tax have been paid. Total operating cost direct factory cost, plus administration, selling anddistribution overheads.This operating profit figure is set against the total assets figure in the balance sheet. The percentagerelationship between the two values gives the rate of return being earned by the total assets. Therefore thisratio measures how well management uses all the assets in the business to generate an operating surplus.Return on total assets uses the three main operating variables of the business.
•
Total revenue
•
Total cost
•
Assets employedIt is therefore the most comprehensive measure of total management performance.
CONCEPT QUESTIONS
ROI COMPOSITION
ROI consists of two components viz.
Profit margin, and
Investment turnover As shown below:ROI = Net profitInvestmentOR ROI = Net profitxSalesSales Investment in Assets
 
http://www.linny.org/forums/ The basic elements of the return on investment ratio can be shown in the form of a Du Pont Chart.
TWO WAYS OF IMPROVING RETURN ON INVESTMENT – 
The earning power or the return on investment ratio is a central measure of the over all profitability andoperational efficiency of the firm. It shows the interaction of the profitability and activity ratios. It implies thatthe performance of a firm can be improved either by generating more sales volume per rupee of investment or  by increasing the profit margin per rupee of sales.Example – Earning power (ROI) = Net profit after taxes i.e.Total assets.Earning power (ROI) = Net profit after taxesxSalesSales Total assets Assume a bThis ratio can be improved by either improving a or b.a can be improved by increasing the net profit for the same amount of sales i.e. increase the profit margin. b can be improved by increasing the sales volume for the same amount of investment.
TAX SHELTER 
Return on investment i.e. the earning power of a firm is the ratio of net profit to total assets. Net profit is the residual income after providing for all the expenses. These expenses include,
Cost of direct material, labour and variable expenses
Operating costs like salaries, wages etc.
Fixed costs like interest and taxes.Return on investment can be improved by increasing the profit margin for the same volume of sales. Profit can be further improved by reducing costs. One of the elements of cost is interest payment.One way of keeping the costs under control is by maintaining a proper balance between equity and debt.Debt carries a fixed charge known as interest, which has to be paid irrespective of the amount of profits.Equity does not carry a fixed charge and can be paid from the net profits after allowing for all the expenses.The return to the equity holders i.e. payment of dividend is not a legal binding on the firm.The interest on debt is tax deductible but the equity dividends are not tax-deductible payments. Hence a proper proportion of debt and equity can be used to improve return on investment.
28%DEBT = 14% PREFERENCE SHARES, TAX RATE=50%
The above statement can be explained as follows:Interest on debt is tax-deductible. Therefore, a 28% interest on debt would mean an interest payment of 28(1-.50)= 14% i.e. same as 14%interest on preference shares.
SOCIAL WEALTH
The shareholders of a company form a part of the society. Their investments in the company form a large part of social wealth. As the society provides finance to a company, the goal of Financial Management is tomaximise the present wealth of the owners i.e. equity shareholders in a company. It is defined as value
 
http://www.linny.org/forums/ maximisation. The wealth of the shareholders is represented in the market value of equity shares. Themarket price of a share serves as an index of the performance of the company. It indicates how wellmanagement is doing on behalf of stockholders. The factors that bear upon the market price of stock are the present and prospective future earnings per share, the timing and the risk of these earnings, the dividend andretention policies of the firm and many others. Shareholder’s wealth and in effect social wealth is maximisedonly when the market value of the share is maximised.
DU PONT CHART
Return on InvestmentEarnings as % of sales
multiplied 
Turnover Earnings
divided by
 
Sales Sales
divided by
 
TotalInvestmentSales
minus
Cost of salesPermanent
 plus
WorkinginvestmentcapitalCost of sales
 plus
Selling
 plus
Administrativeexpenses expensesInventories
 plus
Accounts
 plus
CashreceivablesDu Pont control chart:Origin – A system for management control has been designed which is popularly known as the
Du Pont Chart
system of control. This system utilizes the ratio inter-relationships to provide an important series of chartsand indicators calling management’s attention to desirable and undesirable trends of corporate performance.Once a company has developed standards of performance regarding the various ratios, it becomes easy to judge performance changes with such a system.Objective -An important objective of the Du Pont system is to
isolate the elements entering into the final figure in order to appraise the individual factors affecting performance
.Meaning -It may be noted that the analytical chain in this chart is developed along
two tiers
– 
The first sequence
starts with turnover, determined by dividing sales by total investment; total investmentrepresents current assets plus net fixed assets. Current assets include inventories, accounts receivables andcash.In
the
 
second tier
, the sequence starts with earnings as a percentage of sales, calculated by dividingearnings by sales; earnings equal sales less cost of sales, and cost of sales includes cost of goods sold, sellingexpenses, administrative and general expenses.
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