Question

Dear Experts, can you give me hand with the following :

Describe operating profit margin and asset turnover, then explain how each of these ratios can be used to help division managers improve Retrun-on-Investment (ROI).

Thanks a lot for your input!

Answer 1

Operating Profit Margin

Operating margin is a measure of profitability. It indicates how much of each dollar of revenues is left over after both costs of goods sold and operating expenses are considered.

The formula is for calculating operating margin is:

Operating Margin = Operating Earnings / Revenue

HOW IT WORKS (EXAMPLE):

It is important to understand what expenses are included and excluded when calculating operating margin. The calculation starts with operating earnings, which is equal to revenue minus cost of goods sold, labor and other day-to-day expenses incurred in the normal course of business. It typically excludes interest expense, nonrecurring items (such as accounting adjustments, legal judgments or one-time transactions) and other income statement items not directly related to a company's core business operations.

Asset Turnover:

Definition: Asset turnover ratio is the ratio between the value of a company’s sales or revenues and the value of its assets. It is an indicator of the efficiency with which a company is deploying its assets to produce the revenue. Thus, asset turnover ratio can be a determinant of a company’s performance. The higher the ratio, the better is the company’s performance. Asset turnover ratio can be different from company to company. Usually, it is calculated on an annual basis for a specific financial year.

Description: Asset turnover ratio can be calculated by considering the average of the assets held by a company at the beginning of the year and at the end of a financial year and keeping the total number of assets as the denominator. The ratio can be higher for companies in certain sectors than others. For example, the retail sector yields the highest asset turnover ratio. According to a survey the retail sector scored an asset turnover ratio of 2.05 in 2014. Retail companies generally have small asset bases, but high sales volumes. The asset turnover ratio is a key constituent of DuPont analysis, a method the DuPont Corporation began using at some point in the 1920s. DuPont analysis basically breaks down return on equity into three parts, asset turnover, profit margin and financial leverage. The asset turnover ratio can be calculated by dividing the net sales value by the average of total assets.
Asset turnover = Net sales value/average of total assets
Generally, a low asset turnover ratio suggests problems with surplus production capacity, poor inventory management and bad tax collection methods. Low-margin industries always tend to have a higher asset turnover ratio.

ROI:

ROI (return on investment) equals sales margins divided by the firm’s capital turnover ratio. This equation requires first finding the sales margin and then the capital turnover ratio; then dividing the former by the latter. This is useful to benchmark a division or product line but should not be the final consideration in judging performance. A more strategic assessment is required that goes beyond ROI in order to make smart business decisions.

Sales Margin

Sales margin is the first component of the ROI equation. Sales margin is the profit that is left over from the sales a firm makes minus the company’s cost of goods sold, selling and administrative expense, depreciation, tax or interest expense. The margin is simply the firm’s sales number minus the expense line items. Sometimes the margin is expressed as a dollar figure; other times the sales margin percentage is calculated. This is simply the sales margin dollars divided by the sales dollars.

Capital Turnover

Turnover is the investment turnover ratio of the company. To calculate this number, take the firm’s sales figure and divide it by the company’s invested capital. This is a measure of how effective a company is at generating sales from the assets that have been invested into it. If a company has increased sales faster than it has added assets, the ratio will improve, reflecting operational improvement.

Example

In order to calculate ROI, take the two components and divide sales margin by the investment turnover ratio. For example, if a company had sales of $100 million and income of $20 million, the sales margin would be $20 divided by $100 or 20 percent. In this example we’ll assign the firm invested capital of $350 million. The investment turnover ratio is sales divided by invested capital -- $100 divided by $350 -- or 29 percent. The ROI is sales margin divided by investment turnover -- or, in this example, 20 percent divided by 29 percent -- which equals 69 percent.