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Review questions

Sketch of the structure of a profitability analysis

ROIC (return on invested capital) after tax is measured as:

Mathematical formula

ROIC before tax is measured as:

Mathematical formula

Profit margin after tax is defined as:

Mathematical formula

Profit margin before tax is defined as:

Mathematical formula

The turnover rate of invested capital is defined as:

Mathematical formula

To avoid the impact of different tax rates across firms, ROIC should be measured before tax when performing a benchmark analysis. Since taxes are an expense for shareholders ROIC should be measured after tax when measuring value creation.

One explanation is a decrease in the profit margin; i.e. operating expenses grow more than revenue.

Another explanation is a decrease in the turnover rate of invested capital;  i.e. the utilisation of invested capital relative to revenue.

ROICE itself over time, weighted average cost of capital (WACC) and peers’ ROIC.

Improve revenue (develop better products, increase sales of existing products, entering new markets etc.)

Reduce costs (production, sales, distribution, marketing, administration etc.)

Change the product mix (improve sales on high margin products)

False – it has invested capital 90 days on hand (360/4.0)

  • Improve revenue while maintaining invested capital at the same or at even lower level
  • Reduce invested capital while maintaining revenue at the same or an even higher level (reduce inventory, accounts receivable and extend accounts payables etc.).

Index numbers show the trend in important line items. However, index numbers do not reveal the relative size (importance) of each item. For this purpose, common size analysis is more useful. Common-size analysis scales each item as a percentage of for instance revenue or total assets.

Mathematical formula
Mathematical formula

Where

ROIC = Return on invested capital

NBC = Net borrowing cost measured as a percentage

NIBL = Net interest bearing liabilities*

BVE = Book value of equity

* Equal to net financing assets and liabilities using the terminology of the analytical balance sheet

The appropriate benchmark is the cost of equity (shareholders’ required rate of return)