Return on Investment: NikoTech
After a study of the relationship between supply chain tactics, the income statement and the balance sheet, management must come full circle and complete the ROI calculation for NikoTech. Remembering that the DuPont formula is "a function of the profit margin and the rate of turnover of invested capital," the performance of margin versus turnover is immediately set apart. Consider the Y1 and Y2 results detailed in Table 15.1.
Table 15.1: Y1 and Y2 Return on Investment
ROI = net income/sales x sales/total assets. ROI = net income/total assets.





Given the amount of discussion dedicated to financial analysis in general, as well as its specific application to NikoTech's business model, management is well prepared to make a critical evaluation of the makeup of ROI. Additionally, Mr. Sloan reminds the analyst to "note only that you can get an increase in ROI by increasing the rate of turnover of capital in relation to sales as well as by increasing profit margins." This point speaks to one of the central themes of ratio analysis throughout the NikoTech discussion, namely that in order for the quotient to grow, the numerator must be increased or the denominator decreased.
The above points hold currency for both margin and turnover. For example, in the case of ROI, the methods of improving net profit margin are to increase net profit or, technically, to decrease sales. Because public companies are measured as much by topline growth as net income, the option to achieve the same or greater earnings with less sales is really not an option at all. Therefore, the key is to continue to have sales grow, but to have net income grow at a greater pace in order for the quotient to improve. The turnover calculation, on the other hand, is more consistent with ratio improvement theory in that an increase in sales (numerator) and/or decrease in total assets (denominator) would have the desired effect. A combination of both events would have the greatest impact on this calculation.
Beginning with Y1, the net income figure of $25.2 million divided by total assets of $1.599 billion yields a net margin of 1.75%. Even in the electronics manufacturing services industry, where net income can be slim, NikoTech is still below industry standards. When this number is multiplied by the Y1 total asset turnover figure of 0.9, ROI is registered as 1.6%. Now in the ROI calculation, one can clearly see how underutilized assets have a negative effect on all facets of the business. Conversely, Y2 net margin came in low at 0.74%, with a slight improvement in total asset turnover of 0.95. When the two figures are joined to produce the ROI number, the result is 0.7%.
With the drop in net income weighing heavily on the quotient, the ROI for Y2 dropped almost in half from Y1 to 0.7%. The deaggregation of the components of ROI illuminates the situation in a manner consistent with all prior calculations. Specifically, earnings are way off as a function of sales growth and assets have increased at a pace much greater than the growth in net sales. In this sense, ROI writes the last chapter on the malaise that has plagued NikoTech throughout the entire exercise. Just as the results have been consistent from income statement to balance sheet, so are the remedies discussed thus far in the analysis.
In an effort to show one final illustration of the relationship between supply chain execution and financial outcomes, attention is again directed to the hypothetical Y2 improvements in the area of returns and allowances (R&A). In the earlier discussion of R&A and its relation to total asset turnover, it was proven that an increase in the Y2 sales figure of 50% (coming from R&A) improved total asset turnover from 0.95 to 1.13. Assuming that the net margin in Y2 remained constant at 0.74%, the R&A improvement could also enhance net income performance of NikoTech.
The proposed changes for NikoTech involved an improvement in R&A of 50% (increasing sales by $73.5 million, or up to $1.7715 billion). If the same net margin of 0.7% was assumed for this calculation, net income would improve by $514,500, to $13.114 million. As a complement to the earnings figure, it was also stated that inventories and receivables had been decreased by $210 million, from $660 million to $450 million (bringing total assets in Y2 to $1.566 billion). The change in ROI is summarized in Table 15.2.
Table 15.2: Y2 Return on Investment Improvement
 



 









 


This calculation enforces several points. In relation to net margin, the amount of increase in earnings ($514,500) was not enough to keep pace with the increase in net sales in the denominator. For this reason, net margin remained the same. This makes perfect sense, because the same net margin figure (0.74%) was used to calculate the bottom line impact of the increase in net sales of $73.5 million. The reality is that net margin probably would have been higher based on savings associated with reducing R&A (return freight charges, warehouse handling, administrative expense, etc.).
Moving to potential improvements in asset turnover, the impact is more noticeable. By increasing the numerator of net sales and decreasing the denominator of total assets, there is a double positive for NikoTech. First, the improvement in net sales to $1.7715 billion helps the calculation, signifying that more was done with the same or fewer assets. Since inventory and accounts receivable improved by $210 million, total assets came down to $1.566 billion, a tangible improvement. Compared with the real total asset turnover in Y2 of 0.95, the hypothetical improvements enhanced the number to 1.13. This was already illustrated in the total asset turnover calculation, but when multiplied by the net margin number, the ROI figure is improved from 0.7% to 0.83%.
In real terms, one might view the above improvements as not a lot to talk about. However, it is important to point out that all of the actual and suggested financial improvements effected by NikoTech were based on fixing what was wrong with the model. Little mention has been made of implementing the best practices at NikoTech that would complement its continuous improvement initiatives. From this vantage point, if NikoTech can continue to do what is right while taking measures to eliminate waste, the overall result will most surely be felt.
Even amongst such luminary measures as return on equity and economic value added, the DuPont formula remains as relevant today as it was in 1920. The reason why ROI has transcended time is because of its ability to dissect financial issues, directing executives to the underlying supply chain activities and processes that created those same results. Or, as Martin S. Fridson so accurately stated in his book Financial Statement Analysis: A Practitioner's Guide:
Like most ratio analysis, the DuPont Formula is valuable not only for the questions it answers but also for the new ones it raises. [5]
For these reasons and many more, the DuPont formula will continue to play a major part in the evaluation of global supply chains.
[5]Martin S. Fridson, Financial Statement Analysis: A Practitioner's Guide, John Wiley & Sons, 1995, p. 215.