Return on investment (ROI)

• Return on equity (ROE)
• Return on total assets (ROTA)
• Standards of operating performance

But the age of chivalry is gone. That of sophisters, economists, and calculators, has succeeded; and the glory of Europe is extinguished for ever.

EDMUND BURKE (1729–1797)

Return on investment (ROI)

From the balance sheet we get asset figures and from the profit/loss account we get operating surplus. We relate these two to establish the rate of return.

We have already seen the beginnings of this concept in chapters 4 and 5, but in this chapter we examine it more deeply. 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.

Two measures of return on investment

The two complementary approaches to return on investment that we have already met with will be developed in depth. When these are fully locked into place, variations on the basic themes can be examined and understood without difficulty.

The two measures we will concentrate on are:

• return on equity (ROE)
• return on total assets (ROTA).

The 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. This chapter will concentrate on these two areas. First we will look at methods of calculation, using the Example Co. plc accounts to explore them. Then we will use the aggregated accounts of the US Consolidated Company Inc. to establish what values can be expected from successful businesses.

Return on equity (ROE)

Figure 6.1 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) in the balance sheet.

At the level of the individual business, a good return on equity will keep in place the financial framework for a thriving, 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.

Figure 6.1 Return on equity ratio applied to data from the Example Co. plc

Return on total assets (ROTA)

Return on total assets provides the foundation necessary for a company to deliver a good return on equity. A company without a good ROTA finds it almost impossibe to generate a satisfactory ROE. Figure 6.2 shows how ROTA is calculated, i.e., EBIT/TA.

EBIT 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 includes direct factory cost, plus administration, selling and distribution overheads.

This operating profit figure is set against the total assets figure in the balance sheet. The percentage relationship between the two values gives the rate of return being earned by the total assets. Therefore this ratio measures how well management uses all the assets in the business 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 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. The author’s view is that, for most companies, the balance of advantage lies with the latter school of thought.

Whichever method of calculation is adopted, return on total assets uses the three main operating variables of the business:

• total revenue
• total cost
• assets utilized (some definition of).

ROTA is therefore the most comprehensive measure of total management performance available to us.

Figure 6.2 Return on total assets ratio applied to data from the Example Co. plc

Standards of operating performance

Figure 6.3 shows a summary balance sheet and profit and loss account for the US Consolidated Company Inc. in 2000. The ratio values extracted from these accounts are:

• return on total assets – 17.9 per cent
• return on equity – 27.6 per cent.*

We should remember that the return on total assets is pre-tax and return on equity is calculated using an after-tax profit figure.

These are the rates of return that were achieved by high-level US companies in that year. They are obviously all very good performers and are the gold medallists, as it were, of US industry.

This is not to say that, because they are the largest, they are the most profitable. Indeed better results are often produced by smaller businesses. However, to reach their pre-eminent position, these companies have consistently produced good results, they have survived and grown over many years.

Their continued success is justification for using an average of their combined results as a good target for other firms to aim for.

The rates of return derived from these combined accounts are very high indeed. Levels of inflation have a considerable impact on required rates of return, but allowing for the levels of inflation experienced in recent years, a return on equity of 27 per cent (after corporation tax) is exceptional. It is likely that these returns will not be maintained over the coming years.

Figure 6.3 Summary balance sheet and profit and loss account for the US Consolidated

Return on equity – geographic and sectoral analysis

We have described return on equity as being, probably, the single most important financial ratio we have. It is the great driver of company value. Therefore it is important to know what is happening in the world in terms of this ratio.

From very profitable companies in the US and the UK we get very high values of approximately 25 per cent. Figure 6.4 reflects results of research on simply the largest UK companies in 2000.

The results of current research into approximately 200 worldwide companies are shown in figure 6.5.

In Chart (a), we see that there is a wide spread between the US and UK on the one hand and the EU and Japan on the other. In the former countries, we see returns in the high 20s; in the latter we see rates just above and below 10 per cent.

Some of these variations can be explained by the differences in methods of accounting. For instance, in an environment that has experienced heavy takeover activity, followed by high goodwill write-offs, equity values in the balance sheet no longer give us a true value for shareholders’ investment, and ROE values would be overstated accordingly. It is the author’s opinion that an ROE of 15 per cent is a very satisfactory return.

Across the industrial sectors there is no regular pattern between countries. The low overall return for Japan is consistent across all sectors. The food sector is the worst offender. It yields only 5 per cent. It has shown a dramatic decline over the previous four years, indicating perhaps that the strong yen has caused the greatest damage here.

Outstanding at the other end of the scale are the very high returns being delivered by the US food sector. Included in this category are world-famous names such as Kellogg, Campbell’s Soup, Hershey Foods, etc. These companies with powerful brand identification deliver extraordinary levels of profit.

Figure 6.4 Range of values for ROE of large UK companies in 2000

Figure 6.5 Return on equity by country and by sector

Return on total assets – geographical and sectoral analysis

When we look at standard values for ROTA and ROE, the effects of leverage are clearly seen. Even though ROTA is a pre-tax measure it consistently comes out 3 per cent to 6 per cent less than after-tax ROE values. In the US and UK economies we find results of 14 per cent to 16 per cent. Figure 6.6 shows that 50 per cent of companies clustered within a range of 8.5 per cent plus or minus 3 per cent.

However figure 6.7 shows that these values again far exceed the rest of the world. Japanese companies and EU companies produce about 7 per cent.

The drug sector in the US again shows outstanding results. All sectors in Japan except drugs produce results we would consider to be very low.

Figure 6.6 Range of values for ROTA of large UK companies in 2000

Figure 6.7 Return on total assets by country and by sector

The components of return on total assets

Return on total assets is a key tool in directing management’s day-to-day activities. It provides a benchmark against which all operations can be measured. However as a single figure it simply provides a target. To be useful in decision-making it must first be broken down into its component parts. This will now be done in two stages. First the main ratio is divided into two subsidiary ratios (see figure 6.8), then each of these is further divided into its detailed constituents.

In Stage 1 the two prime subsidiary ratios are identified:

• margin on sales percentage
• sales to total assets ratio (asset turn).

ROTA is calculated by the fraction : EBIT/TA. We introduce the figure for ‘Sales’ and link it to each variable to give us two fractions instead of one. We get the ratios (a)EBIT/sales (profit margin) and (b)sales/TA (asset turn). It is simple mathematics to show that the product of these will always combine to the value of ROTA. This first split is so important that we will take the risk of over-emphasizing it here. The formula is:

We have now derived two most important ratios, ‘profit margin’ and ‘asset turn’. The former identifies profit as a percentage of sales and is often described as the net profit margin. It is a well-known measure and almost universally used in the monitoring of a company’s profitability.

The latter ratio looks at the total sales achieved by the company in relation to its total assets, a measure that is less often emphasized in the assessment of company performance. However its contribution to ROTA is just as powerful and important as the profit margin.

Figure 6.8 The return on total assets ratio and its two subsidiary ratios

We have seen that average return on total assets values for companies from many different industrial sectors tend to fall within a fairly narrow band, e.g. 12.5 per cent, plus or minus 5 per cent. However, the subsidiary ratios that deliver this standardized final result vary widely across different sectors.

Figure 6.9 shows some typical values for companies with vastly different profiles.

Example A

Here we see typical figures for a distribution-type company, where low margins, e.g. 5 per cent to 7 per cent combine with a high asset turn, e.g. 2 times.

Example B

Here the opposite applies. Very high margins and low asset turns are typical of companies that require large quantities of fixed assets. The telecommunications sector generates sales margins in the region of 25 per cent. However, their enormous investment in fixed assets with correspondingly low asset turns means that this margin is only just adequate to make a reasonable return on total assets.

Example C

Here we see fairly average figures, with margins at 10 per cent or more, and asset turn values somewhat greater than 1. Quite a number of medium-sized manufacturing companies have this kind of pattern. The difference between success and mediocrity in this type of business is often less than 2 per cent on margin and a small improvement in asset turn.

Figure 6.9 Indicative margin on sales and sales to total asset ratios for different types of business

‘Margin’ and ‘Sales to Total Assets’ standards

Figure 6.10 illustrates the calculations and results for the US Consolidated Company Inc. An average sales margin of 12.8 per cent is delivered 1.4 times to produce a ‘return on total assets’ value of 17.9 per cent.

A comparison by country (see figure 6.11) shows a strong similarity between companies in the US and the UK. In the US a slightly lower margin is accompanied by a somewhat higher ‘sales to total assets’. However the size of the sample would not allow us to give great statistical significance to these variations.

Companies in the EU seem to operate on lower margins and their asset utilization is also low. Companies in Japan operate on low margins but appear to have a somewhat better assets utilization. This latest finding runs contrary to popular belief. Much has been written about Japanese achievements in operating with very low inventory levels. While this may be true in specific industries it does not seem to hold across a wide range of companies.

It rests with the skill of each management team to discover for itself the unique combination of margin and asset turn that will give their company its own particular, and successful, market niche.

Figure 6.10 Margin on sales and sales to total asset ratios applied to data from the US Consolidated Company Inc.

Figure 6.11 Margin on sales and sales to total asset ratios by country

Sector parameters – return on total assets

In figure 6.12, results of research into top UK companies in 1992 are still used here because they give a dramatic illustration of the interrelationship that exists between the two key variables that determine what a company will achieve in terms of return on total assets.

Chart A shows values for ‘Sales to total assets’ and chart B ‘Margin’ values for six industrial sectors ranging from ‘food’ to ‘health care’. The two charts are almost minor images of one another. High sales to assets ratios are generally offset by low margins and vice versa. It is where the minor images do not exactly match where the high and low performers are located.

The values shown in Chart A of figure 6.12 point to a question concerning business performance that is absolutely critical. What level of investment is required to support any given level of sales? The results displayed here help us to understand why some sectors of industry seem to have a built-in advantage over others.

Chart A shows the high sales to total assets ratios inherent in the food industry. While this ratio is high in both retailing and manufacturing sectors, it is more pronounced in retailing.

Chemicals and stores both have ‘sales to total asset’ ratios that are approximately 20 per cent above the average, but this advantage is mostly offset by their lower margins – particularly in the case of chemicals. The two sectors are still quite good overall.

When we look to the two final sectors, we see a dramatic contrast. The brewing value is very low, with a sales to total assets ratio of about 0.5 times. It may be more informative to turn this ratio upside down and say that it requires $1.60 of assets to carry $1.00 of sales. For any given level of sales, the investment in assets is enormous. In contrast, in the food retailing sector it takes only $0.45 to support $1.00 of sales. The brewing/distilling sector requires almost four times this investment to produce this result.

In the health sector, we note that the ‘sales to total assets’ ratio is also below average but this sector has a margin on sales that compensates by almost 200 per cent for these somewhat high assets. The high margins in brewing are still not sufficient to pay for the very high investment in assets in this sector.

Figure 6.12 Sector values for sales to total assets and margin on sales ratios for data from top UK companies in 1992

* These values are very high, but they have been derived from the results of the most successful US corporations (see appendix 2). Also, ROE values have been boosted by the fact that many of these companies have reduced their equity amount through considerable buy back of shares. For a broader view of ROE, see figures 6.4 and 6.5.

* The links between these two ratios are discussed in chapter 13.