Finance Management Analyzing and improving Management performance
Companies must be able to measure managerial performance if they are to control operations and achieve organizational goals. As companies grow or their activities become more complex, they often attempt to decentralize decision making as much as possible by restructuring into several divisions and treating each as an independent business. The managers of these subunits or segments are evaluated on the basis of the effectiveness with which they use the assets entrusted to them.
Perhaps the most widely used single measure of success of an organization and its subunits is the rate of return on investment (ROI). A related measure is the return to stockholders, known as the return on equity (ROE).
Return On Investment
ROI, which relates net income to invested capital (total assets), provides a standard for evaluating how efficiently management employs the average dollar invested in a business’s assets. An increase in ROI can translate directly into a higher return on the stockholders’ equity. ROI is calculated as
ROI = Net profit after taxes/ Total assets
Example: Consider the following financial data
If Total assets = $100000 and net profit after taxes = $18000
Then, ROI = Net profit after taxes / Total assets = 18000/100000 = 18%.
Improving Return To Stockholders Through Financial Leverage
Generally, a high level of management performance, defined as a high or above-average ROI, produces a high return to equity shareholders. However, even a poorly managed company that suffers from a below average performance can generate an above-average return on the stockholder’s equity, or return on equity (ROE). It can do this through the use of borrowed funds that can magnify the returns paid to stockholders.
A variant on the Du Pont formula, called the modified Du Pont formula, reflects this effect. The formula ties together the company’s ROI and its degree of financial leverage, that is, it use of borrowed funds. Financial leverage is measured by the equity investment or stated another way, dollars of assets held per dollar of stockholders’ equity. This ratio, which is calculated by dividing total assets by stockholders’ equity, gives an indication of the extent to which a company’s assets are financed by stockholders’ equity and borrowed funds.
The return on equity (ROE) is calculated as
ROI = Net profit after taxes/ stockholder’s equity
= (Net profit after taxes / total assets) × (Total assets / Stockholders’ equity)
ROI × Equity multiplier
ROE measures the returns earned on both preferred and common stockholders’ investments. The use of the equity multiplier to convert the ROI to the ROE reflects the impact of the leverage on the stockholders’ return.
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