5
Return on investment
This chapter will:
- Review the term ‘return on investment’
- Explore its various derivative measures
The generic term ‘return on investment’ is one of the most important concepts in business finance.
Every dollar of assets can be matched to a dollar of funds provided by the financial markets. The providers of these funds need to be paid. Payment comes from the operating surplus (or profit) generated from the utilisation of assets. Return on investment measures operating surplus as a proportion of the underlying assets/funds required to generate that surplus.
If return on investment is equal to or greater than the cost of funds, then the business is viable. However, if return on investment (in the long term) is less than the cost of funds, the business has no future.
The concept of return on investment is universal, but the methods of measurement vary widely. This lack of consistency causes confusion in the minds of many financial and non--financial people alike. This chapter aims to clear this confusion.
When we wish to examine a company’s performance, we look at its absolute profit (from the profit/loss account) in relation to the assets tied up in the business (from the balance sheet). But the question arises: which figure should we take from the profit/loss account, and which figure from the balance sheet?
Figure 5.1 shows the accounts for the Example Co. plc with values extracted for:
| Profit and loss account | Balance sheet |
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Figure 5.1 Important terms from the profit and loss account and balance sheet using data from the Example Co. plc
Performance is measured by establishing relationships between these two sets of values.
However, we have a choice as to which value we use from each statement. Earnings before interest and tax could be measured against total assets or capital employed or net worth. We could do likewise with earnings before tax and earnings after tax. This gives us nine possible measures of performance. In practice, we meet with all of these measures and even with some other variations.
Various names are given to these linkages or ratios between the balance sheet and the profit and loss account values. In practice almost all combinations are used. Their respective popularity changes according to the latest trend.
The names come and go, becoming popular for a while and then maybe disappearing. A selection of these measures are:
- ROA (return on assets)
- ROTA (return on total assets)
- RONA (return on net assets)
- ROCE (return on capital employed)
- ROIC (return of invested capital)
- ROE (return on equity).
This multiplicity of terms causes difficulty to the non-specialist, but the point to remember is that these are not different ratios. They all simply measure in one way or another the return on investment. The name used does not greatly matter. What is important, however, is that we know which profit and loss figure is being related to which balance sheet figure.
This book will initially use only two measures of return on investment:
- ROTA (return on total assets)
- ROE (return on equity).
ROTA gives a measure of the operating efficiency of the total business.
ROE assesses the return made to the equity shareholder.
Each will be covered in detail below.
We do not imply that these are the only correct measures or that all others are deficient in some way. However, they are two of the better measures. There is sound logic for choosing them in preference to others, as we will see in due course.
These two separate measures are necessary because they throw light on different aspects of the business, both of which are important.
Return on total assets looks at the operating efficiency of the total enterprise, while return 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 the shareholders. A good figure brings success to the business – it results in a high share price and makes it easy to attract new funds. This will enable the company to grow, given suitable market conditions, and leads to greater profits. In turn, this leads to high value and the continued growth in wealth of its owners.
At the individual business level, a good return on equity will keep in place the financial framework for a thriving, growing enterprise. At the total economy level, return on equity drives positive contributions such as:
- industrial investment
- growth in gross national product
- employment
- government tax receipts.
It is, therefore, a critical feature of the overall modern market economy as well as of individual companies.
Figure 5.2 shows how return on equity is calculated. The figure for EAT from the profit and loss account is expressed as a percentage of OF (owners’ funds/net worth) from the balance sheet.
Return on total assets (ROTA)
Return on total assets provides the foundation necessary for a company to deliver a good return on equity. ROTA is the most important driver of ROE. A company without a good ROTA finds it almost impossible to generate a satisfactory ROE.
Figure 5.3 shows how ROTA is calculated. The figure for EBIT (or operating profit) from the profit and loss account is expressed as a percentage of total assets from the balance sheet.
ROTA calculates a rate of return earned on assets and therefore measures how well management utilises the business’s assets to generate an operating surplus.
Some practitioners contend that the figure taken from the balance sheet should include the long-term funds and only those short-term funds for which a charge is made, i.e. STL (short-term loans). Their position is that assets funded by ‘free’ creditors should not be included in the rate of return calculation. There is considerable merit in this argument, but a potentially stronger counter-argument is that the rate of return issue is separate from the funding issue and that assets should produce a return irrespective of the method of funding. For example, some companies choose to fund by suppliers’ credit, others from a bank loan.
Whichever method of calculation is adopted, return on total assets uses the three main operating variables of the business:
- total revenue
- total cost
- assets utilised.
ROTA is therefore the most comprehensive measure of total management performance available to us.
Alternative return on investment measures
There are many other possible variations of ‘return on investment’. Some may well be more suitable for particular types of businesses. One that is widely used is ROCE (return on capital employed).
As covered in Chapter 2, capital employed is calculated as total assets less current liabilities. The corresponding profit and loss value used is EBIT. Because a smaller denominator is used in calculating return on capital employed, we would expect a higher answer than for return on total assets.
When new expressions for these ratios are encountered it is often not clear which profit and loss value is being measured against which balance sheet value. Then the question to ask is ‘How is it calculated?’ When you know what the calculation method is, it is as easy to work with one combination as another. However, there is a certain logic that should be followed in deciding on any particular ratio – if the value from the balance sheet includes loans, then the profit and loss value should include the corresponding interest charge and vice versa. This rule is not always adhered to and the resulting answers can be suspect.