The use of Return on Investment (ROI) causes managers to consider income and investment when making decisions. A company’s return on investment is the measure of income or profit divided by the investment required to obtain that income or profit (Horngren, Sundem, Stratton, Burgstahler, and Schatzberg, 2008). ROI can be used as a test of profitability. The formula for ROI is ROI = Net Income ? Total Assets. Guillermo, like most investors wants the maximum income, considering he is given the same risks for any given amount of resources required.
Return on sales and capital turnover are the factors that make up ROI and any change in either will affect the ROI as long as one of them does not change. That means that any improvement to either the return on sales or capital turnover without changing the other will result in an improvement in the ROI (Horngren at el. , 2008). Return on sales is the income divided by revenue and capital turnover is the revenue divided by invested capital (Horngren at el. , 2008). The ROI as well as return on sales can be improved by decreasing expenses without increasing investment or increasing sales.
ROI can also be increased by decreasing assets, which will also increase capital turnover (Horngren at el. , 2008). The most effective way for Guillermo to improve the company’s performance is to decrease the company’s assets as a means to improve or increase ROI. Some of the assets Guillermo may wish to consider are equipment or possibly even inventories. Being that Guillermo Furniture Store is not a large corporation, but rather a smaller company that has a more centralized operation, the ROI calculation is better if based on the DuPont Ratio.
The formula for the DuPont Ratio is written as ROI = (Net Income ? Revenue) times Revenue ? Total Assets (Horngren at el. , 2008). Residual Income is also known as economic profit, which is the after-tax operating income less a capital charge (Horngren at el. , 2008). The main objective of knowing the residual income is to determining how much the after-tax operating income exceeds the amount that is being paid for capital. When considering residual income, both capital charge and cost of capital must be taken into consideration.
The cost of capital is the amount Guillermo must pay in order to acquire more capital. It does not matter whether the furniture store has to acquire any new capital immediately. Capital charge would be the company’s cost of capital multiplied by the amount of the investment (Horngren at el. , 2008). References Horngren, C. T. , Sundem, G. L. , Stratton, W. O. , Burgstahler, D. and Schatzberg, J. (2009). Introduction to Management Accounting ( Fourteenth Edition). Prentice Hall. Pearson Education, Inc. Retrieved from University of Phoenix, ACCT 561 Material.