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Monday, September 5, 2011

Analyzing and Improving Financial 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 sub-units 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 sub-units 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 relates net income to invested capital (total assets). It 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 profits after taxes/ Total assets

If the total assets = $100,000 and net profit after taxes = $18000, then

ROI = Net profits after taxes/ Total assets = $18000/$100000 = 18%.

Du Pont Formula

ROI can be broken down into factors – profit margin and asset turnover. In the past, managers have tended to focus only on profit margin and have ignored the turnover of assets. However, having excessive funds tied up in the assets can be just as much a drag on profitability as can excessive expenses. The Du Pont Corporation was the first major company to recognize the importance of looking at both net profit margin and total asset turnover in assessing the performance of an organization. The ROI breakdown, known as the Du Pont Formula, is expressed as a product of these two factors.

ROI = Net profit after taxes/ Total assets × Sales/ Total assets = net profit margin × total asset turnover

No one ROI is satisfactory for all companies. Sound and successful operation results in an optimum combination of profits, sales and capital employed, but the precise combination necessarily varies with the nature of the business and the characteristics of the product.

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 holders. However, even a poorly managed company that suffers from a below-average performance can generate an above-average return on the stockholders’ equity, or return on equity (ROE). It can do this through the use of borrowed funds that can magnify the returns paid out to stockholders.

A variant of 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, its use of borrowed funds. Financial leverage is measured by the equity multiplier. 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/ stockholders 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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