Accounting return measures compute the profitability of an individual or an organisation using the numbers presented in their income statement and balance sheet. For instance, net profit margin (NPM) measures the profitability using the profit after tax (PAT) and net revenue, while return on investment (RoI) measures the overall return of the entity using the after-tax operating profit and the capital invested figures of the entity.
The difference between the NPM and the RoI figures is that the former draws the inputs only from the income statement, while the latter draws the inputs both from the income statement and the balance sheet of the entity.
For an individual receiving other income, it has to be subtracted from the total income to arrive at the operating surplus. But Rohit Chauhan (as shown in the graphic) does not have other income, so it is excluded from the calculation.
Flaw in NPM computation
The above stated numbers describe the profitability of the individuals/organisations from the accounting perspective. These numbers do not indicate whether the individuals/organisations are earning excess returns or not.
What is not included in the above calculations? The above calculations do not include the cost of capital in arriving at the actual returns/profits/surplus earned by the entities. For instance, let us assume that Rohit has a total capital invested of R60 lakh consisting of R45 lakh as his own equity and the remaining R15 lakh as 16% long-term borrowing/debt. Also, assume that he wants to have 18% as his required rate of return on his capital, i.e., cost of equity.
Note that the income statement has deducted only the cost of debt R2.4 lakh in arriving at the profitability numbers.
What is Excess Return: Economic value added (EVA), a popular measure in finance which states that any investment is worth it only when it generates the excess return. It is computed by multiplying the capital invested of an entity with its excess of RoIC (return on invested capital) over its weighted average cost of capital. So, EVA is one of the excess return measure.
Implications
Increase the Return on Invested Capital (RoIC): This is possible either by increasing the revenue or decreasing the expenses or doing both. Increasing revenue is not a feasible option for Rohit in the short run as he is a salaried employee.
But decreasing the expenses is possible for Rohit. He can prepare a common-size statement to trace the expenses that are the major contributors for the inadequate ROIC earned by him.
Reduce the Weighted Average Cost of Capital (WACC): This is possible by decreasing his cost of debt and cost of equity. His cost of debt can be reduced by improving his credit worthiness. For instance, he can increase his personal interest cover ratio. Here another option would be to replace the higher cost debt with a lower cost debt. Cost of equity is higher because his required rate of return is very high.
Perhaps , he can examine whether he can reduce his required rate of return. If it is not possible, then he can change the proportion of debt and equity capital in such a way that he makes use of the lowest source of capital at the optimal proportion.
The world today is searching for investment avenues that generate positive excess returns. Positive excess returns are possible only when the entity earns excess RoIC over its weighted average cost of capital. Growth in earnings will bring prosperity only when it is accompanied by positive excess returns.
The writer teaches accounting and finance courses at IIM Ranchi