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Making a good return is the objective, but what exactly is ROI?

ROI is the operating profit from normal activities before tax and interest charges divided by the capital employed (used to generate the profit). See Table 2.1.

TABLE 2.1 ROI and sub-ratios

ROI and sub-ratios

Operating profit is to be found in the P&L account - income statement as the net amount derived from a period's sales less costs (P&L accounts are studied in Chapters 3 and 6). Understanding the drivers of profit is essential as this will explain possible strategies and how they might be delivered. Capital employed can be understood from two angles:

1 The net amount representing the assets less liabilities employed in the business; for example, a retail property plus fitting plus stock less amounts owed to suppliers. This is the physical capital employed.

2 Money invested (shareholders' capital) - investment in the form of share or stock capital plus past profits reinvested each year plus loans from lenders.

It is important to understand these views as they perhaps explain the quite different approach to, or implementation of, strategies. Most managers in business deal with the physical - making the assets deliver, but they may be emotionally tied to the business: they work with fellow humans - employees and so on. The finance folk can sit on the 49th floor of corporate headquarters: all they ponder is money - invested capital. There are no emotions here - just ruthless pursuit of return. Is this unfair? Perhaps, but it does help explain attitudes to investment strategy.

The numbers for capital employed can be found in the balance sheet -statement of financial position. We shall study this in Chapters 3 and 6. Understanding the composition of the balance sheet is essential, as this will explain the possible strategies and how they might be delivered.

Now let's look at some 'textbook' figures.

 
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