ANALYZING COMPANY’S FINANCIAL PERFORMANCE

USING RETURN ON INVESTMENT (ROI), RESIDUAL INCOME (RI)

AND ECONOMIC VALUE ADDED (EVA)

AND EACH BENEFIT FOR DECISION MAKING

(A CASE STUDY IN PT X PERIOD 2009-2011)

SKRIPSI

By

Aida Nur Fitria 008200900005

Presented to

The Faculty of Economics, President University In partial fulfillment of the requirements

For Bachelor Degree in Economics, Major in Accounting

President University

Cikarang Baru – Bekasi

Indonesia

2013

ii

PANEL OF EXAMINERS APPROVAL SHEET

Herewith, the Panel of Examiners declares that skripsi entitled “Analyzing Company’s

Financial Performance Using Return on Investment (ROI), Residual Income (RI)

and Economic Value Added (EVA) and Each Benefit For Decision Making (A Case

Study in PT X Period 2009-2011)” that was submitted by Aida Nur Fitria majoring in

Accounting from the Faculty of Economics was assessed and approved to have passed

the Oral Examination on March 13, 2013.

Chair, Panel of Examiner,

(Mr. Drs. Umar Subandijo, MBA)

Examiner 1

(Mr. Mairizal Chaidir, Ak.,M.Comm)

Examiner 2

(Mrs. Monika Kussetya Ciptani, SE,Ak.,M.Ak)

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SKRIPSI ADVISOR

RECOMMENDATION LETTER

This skripsi entitled “Analyzing Company’s Financial Performance Using Return on

Investment (ROI), Residual Income (RI) and Economic Value Added (EVA) and

Each Benefit For Decision Making (A Case Study in PT X Period 2009-2011)”

prepared and submitted by Aida Nur Fitria in partial fulfillment of the requirements for

Bachelor Degree in Economics-Majoring in Accounting, has been reviewed and found

to have satisfied the requirements for a thesis fit to be examined. We therefore

recommend this skripsi for Oral Defense.

Cikarang, Indonesia, .............................

Acknowledge Skripsi Advisor,

(DR. Sumarno Zain,SE,Ak.,MBA) (Mrs. Monika Kussetya Ciptani, SE,Ak,M.Ak)

Head, Accounting Study Program

iv

DECLARATION OF ORIGINALITY

I declare that this skripsi entitled “Analyzing Company’s Financial Performance

Using Return on Investment (ROI), Residual Income (RI) and Economic Value

Added (EVA) and Each Benefit For Decision Making (A Case Study in PT X

Period 2009 -2011)” is originally written by myself based on my own research and has

never been used for any other purpose before. I therefore request the skripsi for Oral

Defense.

Cikarang, Indonesia, ...................................

Researcher,

(Aida Nur Fitria)

008 2009 00005

v

“Analyzing Company’s Financial Performance Using Return on Investment (ROI), Residual Income (RI) and Economic Value Added (EVA) and Each Benefit For Decision Making (A Case Study in PT X Period 2009-2011)”

ABSTRACT

Evaluating the company’s financial performance is important for the related parties to know the manager’s effectiveness in managing the company’s assets to generate more profit and offer the higher return of money that being invested by the shareholders. The methods that are used by the researcher to evaluate the company’s financial performance by considering both, profit and return of capital invested, are return on investment, residual income and economic value added. Through these methods, the researcher can evaluate the company’s financial performance and determine which method provides useful information for the managers to evaluate the company’s financial performance.

According to the result, the performance of PT X which evaluated by Return on Investment shows that the performance in 2009 is better than performance in 2010 and 2011 while performance of PT X in 2011 is worse than performance in 2009 and 2010. By using Residual Income, it shows that the performance of PT X in 2011 is good whereas the performance of PT X in 2009 and 2010 is bad. Different from Return on Investment and Residual Income, the Economic Value Added calculation shows that all financial performance of PT X within three years is good.

According to the result, the researcher has several recommendations for the company such as the managers should evaluate the company’s performance in dollar amount rather than the percentage and the managers must consider the performance of company in the long-run rather than short-run performance. Thus, the researcher recommends economic value added to support the long-term decision and company’s development.

Key words: Performance Measurement, Return on Investment, Residual Income and Economic Value Added

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ACKNOWLEDGEMENT

Finally, I have finished my skripsi to fulfill the requirement for Bachelor Degree in

Economics, Major in Accounting. Through finishing this skripsi, I have done my life in

President University. There are a lot of beautiful memories and unforgettable that has

been occurred while studying in President University such as getting entrepreneurship,

internship, mid and final exam that always make me crazier and other pleasant

memories.

First of all, I express my gratitude to Allah Subhanahu Wa Ta’ala for blessing, love,

opportunity, health, and strong so I could complete this skripsi for about 2 months. In

finishing this skripsi, there were a lot of things that I felt such as worry, sadness and

confuse, but people have given me motivation, advice, support, and even help me to get

some inspiration. In this valuable chance, I express my gratitude and appreciation to

them for their contribution, and the people are:

1. Mr. Dr. Drs. Chandra Setiawan, MM., Ph.D as Rector of President University.

Thank you very much for your support on my skripsi.

2. Mr. Misbahul Munir, Ak., MBA as Dean of Faculty of Economics. Thank you

very much for your support and guidance on my skripsi.

3. Mr. DR. Sumarno Zain, SE, Ak., MBA as Head of Accounting Study Program.

Thank you very much for your support on my skripsi.

4. Mrs. Monika Kussetya Ciptani, SE, Ak., M.Ak as my skripsi advisor. Thank you

very much for your patient, advices, guidance, and knowledge during I was

writing my skripsi.

5. My beloved family especially dedicated for my beloved Mama and Papa. Thank

you for your supports, suggestions, and prayer, so I can finish this skripsi.

6. Bpk. Hj. Soegeng as a founder and owner of PT Haluan Utama Maju. Thank you

for your support, so I have an opportunity for continuing the study in President

University, and All staff of PT Haluan Utama Maju. Thank you for your support

7. My beloved friend, Nurlaily Febrianti who has given me the opportunity to get

the data for my skripsi to support my analysis about company’s financial

performance. Thus, I can finish this skripsi and get good mark.

8. My soul mate, Sedya Lutfie Hardini. We have spent most of our time together

for 6 years. A lot of sweet memories that we have done together, happiness,

sadness, and many things. You always give me suggestion, spirit and support

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especially for finishing this skripsi. Many thanks for you Lutfie, we fight

together to get best result.

9. My beloved friends; Aisyah, Ayu, Emy, Fatimah, Kasih, Lavina, Resti, Titin,

and Vanny. Thank you for supporting and giving me inspiration when I’m

getting hard to finish this thesis. Thank you very much for both of your teaching

and guidance. Love you all, guys.

10. My lovely friends ACC batch 2009, I am happy to have you as a part of my life

and spend our time together during 3 years to get study in President Accounting.

I wish all of us will meet in graduation sooner.

11. Last is for all people who can not be mentioned one by one. Many thanks for the

supports.

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TABLE OF CONTENTS

Inside title .......................................................................................................................... i Panel of Examiners Approval Sheet ........................................................................................ ii Thesis Adviser Recommendation Letter ................................................................................ iii

Declaration of Originality ............................................................................................... iv Abstract ............................................................................................................................ v Acknowledgement........................................................................................................... vi Table of Contents .......................................................................................................... viii List of Tables.................................................................................................................... x List of Figures ................................................................................................................. xi CHAPTERS: ............................................................................................................................... 1

I. INTRODUCTION ............................................................................................ 1 I.1 Research Background .............................................................................. 1 I.2 Problem Identification and Statement ..................................................... 3 I.3 Research Scope and Limitation ............................................................... 4 I.4 Research Objectives ................................................................................. 4 I.5 Research Benefits .................................................................................... 4 I.6 Research Method ..................................................................................... 5 II. LITERATURE REVIEW.................................................................................. 6 II.1 Financial Reporting ................................................................................. 6 II.1.1 Definition of Financial Reporting ................................................... 6 II.1.2 Type of Financial Reporting ..................................................... 6 II.1.3 Objective of Financial Reporting ............................................. 8 II.1.4 Financial Reporting Users ........................................................ 8 II.2 Performance Measurement ...................................................................... 9 II.3 Measuring the Financial Performance of Company .............................. 10 II.3.1 Return on Investment (ROI) ................................................... 11 II.3.1.1 Definition of return on investment ........................ 11 II.3.1.2 Methods used to Increase ROI .............................. 18 II.3.1.3 Advantages and Disadvantages of ROI ................. 19 II.3.2 Residual Income (RI) ............................................................. 20 II.3.2.1 Definition of Residual Income ............................. 20 II.3.2.2 Advantages and Disadvantages of RI .................... 22 II.3.3 Economic Value Added .......................................................... 23 II.3.3.1 Definition of Economic Value Added .................... 23 II.3.3.2 Procedures to calculate EVA ................................. 24

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II.3.3.3 Advantages and Disadvantages of EVA................. 26 II.4 Cost of Capital ...................................................................................... 27 II.4.1 Definition of Cost of Capital ................................................. 27 II.4.2 Factors That Affect the WACC ............................................. 34 II.6 Research Framework ............................................................................ 35 III. METHOD OF DATA PROCESSING AND COMPANY’S EXISTING

CONDITION .................................................................................................. 36 III.1 Method of Data Processing ................................................................... 36 III.1.1 Types and Data Resources .................................................... 36 III.1.2 Data Collection Method ........................................................ 36 III.1.3 Data Processing Method ....................................................... 37 III.2 Company’s Existing Condition ............................................................. 40 III.2.1 Profile of PT X ...................................................................... 40 III.2.2 The company’s objectives ..................................................... 40 III.2.3 Company’s Product ............................................................... 41 III.2.4 Organization Structure of PT X ............................................ 41 IV. ANALYSIS AND EVALUATION .................................................................. 45 IV.1 Performance Measurement of PT X ..................................................... 45 IV.2 Analyze Return on Investment ............................................................. 46 IV.3 Analyze Residual Income ..................................................................... 53 IV.4 Analyze Economic Value Added .......................................................... 58 IV.5 Comparison of Method and Its Benefit for Decision Making In Investment…...…….…………………………………………………..74

V. CONCLUSION AND RECOMMENDATION ................................................ 75 V.1 Conclusion ............................................................................................. 75 V.2 Recommendation ................................................................................... 78 BIBLIOGRAPHY APPENDICES

I. Statement of Financial Position of PT X during three years

II. Statement of Comprehensive Income of PT X during three years

III. Bank Indonesia Rate for three years period (2009-2011)

IV. Jakarta Composite Index for three years period (2009-2011)

V. Market Stock Price for three years period (2009-2011)

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LIST OF TABLE

Table-4.1: Company’s Statement of Financial Position ............................................ 46

Table-4.2: Company’s Statement of Comprehensive Income ................................... 46

Table-4.3: Return on Investment ............................................................................... 49

Table-4.4: Residual Income ....................................................................................... 56

Table-4.5: Systematic Risk (Beta) 2009-2011........................................................... 66

Table-4.6: Economic Value Added ........................................................................... 69

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LIST OF FIGURES

Figure-2.1: Performance Measurement....................................................................... 10

Figure-2.2: Elements of Return on Investment ........................................................... 19

Figure-2.3: Types of Capital ....................................................................................... 29

Figure-2.4: Research Framework ................................................................................ 35

Figure-3.1: Procedures in processing data .................................................................. 39

Figure-3.2: Company’s Organization Structure .......................................................... 42

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1

CHAPTER I

INTRODUCTION

I.1 Research Background

Today, companies must be able to attract the customer’s attention and compete

with other company. In this competitive world, companies can compete with the others

through improving performance of the company such as running the business more

effective and innovative. Through performance improvement, company may increase its

profit to continue the company business and avoid the bankruptcy. Therefore, the

managers need the performance measurement to measure or evaluate the company’s

performance and enable them in decision making especially for the performance

improvement.

The managers can measure or evaluate the company’s performance through

analyzing the financial reporting which describes the whole transaction of the company

within certain period. Financial reporting analysis provides useful information for the

users regarding to the company’s achievement. The method often used to evaluate the

company’s financial performance is financial ratios. It is measured by comparing

financial data stated in the financial reporting items such as statement of financial

position and statement of comprehensive income. In this research, the researcher uses

return on investment ratio, residual income and economic value added to measure the

company’s financial performance because these methods not only measure the profit

earned but also measure the return of money that being invested.

In running the business, profit is described as the company’s achievement and

therefore a lot of companies perform several procedures or methods to increase the

company’s value. Nevertheless, it is not sufficient for the company to measure or

2

evaluate the financial performance of company. It shows that the high profit achieved

by the company does not mean the company has run the business more effective. The

company has performed the business well, if managers could manage its asset well

through allocating the asset to generate more profit and to provide value added for the

wealth of company. Therefore, the managers must identify or consider other aspects in

evaluating the company’s performance.

Managers may use the return on investment to evaluate the financial

performance of company. Investment is very important in a company because

investment related to the source of funds used and the expected return on investment.

Each company expects that the fund invested for the company’s operation used

effectively and they could achieve the return which suitable with the company’s

desired. Spiceland, Sepe, and Tomassini (2004) defined return on investment ratio as “a

part of profitability ratio to measure the firm’s overall effectiveness in generating profits

with its available assets.” (p.238) Return on investment shows the profit generated from

each dollar asset. Return on investment information is useful for the investors to ensure

whether the funds invested have been used according to the company’s objective.

Usually, the good performance of a company provides higher rate of return on

investment and in contrary, the bad performance of a company provides lower rate of

return on investment. The high return on investment means the managers are able to

manage its profit for enhancing its assets and capable to manage them for generating the

profit. The managers usually keep monitoring and maximizing return on investment in

order to achieve good performance for their division.

Besides return on investment, there are other methods used to evaluate the

financial performance of company which are Residual Income (RI) and Economic

Value Added (EVA). Garrison and Noreen (2003) defined Residual Income (RI) in

3

measuring company’s performance as “the net operating income that investment center

earns above the minimum required return on its operating assets.” (p.534) The residual

income method encourages managers to make investment that are profitable for the

entire company because its evaluation based on residual value achieved from target

return on investment. When the profit earned is higher than the target return on

investment, good performance is achieved and it also provides high rate of return on

investment for the investors.

Another method in evaluating company’s performance is Economic Value

Added (EVA). Charles, Gary and William (2005) argued that “Economic Value Added

(EVA) equals after-tax operating income minus the cost of invested capital multiplied

by the invested capital.” (p.1250) It is a method used to measure economic value of

company through considering the wealth based on company’s ability to cover its cost of

capital. The company has good performance if Economic Value Added (EVA) is higher

than zero (0) or has positive EVA. It means the company is able to cover its cost of

capital and provides value added for the wealth of company. Thus, the company can

provide rate of return according to the investor’s and stockholder’s desired.

According to the research background, the researcher is going to evaluate the

company’s performance using Return on Investment (ROI), Residual Income (RI) and

Economic Value Added (EVA) and its benefit for decision making.

I.2 Problem Identification and Statement

The performance of company varies from one to other company. Through

Return on Investment (ROI), Residual Income (RI) and Economic Value Added (EVA),

the researcher is going to find out:

4

1) How do we measure the company’s financial performance using Return on

Investment (ROI), Residual Income (RI) and Economic Value Added (EVA)?

2) With these methods, which method provides more useful information for the

managers to evaluate the company’s financial performance?

I.3 Research Scope and Limitation

The limitations of this research are:

1) This research studies on Company X and evaluates the financial performance of

Company for two years, since 2009 until 2011.

2) The methods used to evaluate the company’s financial performance are Return

on Investment (ROI), Residual Income (RI) and Economic Value Added (EVA).

3) Analyze the measurement result of Return on Investment (ROI), Residual

Income (RI) and Economic Value Added (EVA) over company’s financial

performance.

I.4 Research Objectives

According to Problem identification, the objectives of this research are:

1) Measuring the company’s financial performance using Return on Investment

(ROI), Residual Income (RI) and Economic Value Added (EVA).

2) Determining which method provides more useful information for the managers

to evaluate the company’s financial performance.

I.5 Research Benefits

For Users:

1) This research provides suggestion and consideration for the company in making

decision to improve and maximize the performance for the future.

5

2) Through analyzing the result, company can decide which method will be

implemented in evaluating the performance of company.

3) This research provides information for the investors in decision making whether

to invest or not.

4) This research provides information for the creditors about company’s ability to

cover its liability and consideration to decide whether give the loan or not.

For Researcher:

1) The researcher could implement the knowledge received when studying in

University.

2) The researcher can enhance the knowledge and understanding deeply about the

Return on Investment and (ROI), Residual Income (RI) and Economic Value

Added (EVA) in evaluating the financial performance.

I. 6 Research Method

The research method applies for this study is qualitative method where the

researcher is doing direct observation or field research to obtain the primary data. The

data collected for this research derives from documentation which is collecting the

reports related to the objects that being observed and having some interview to obtain

more information to support the analysis. In this research, the researcher is going to

discuss about company’s financial performance. Thus, the researcher is going to

observe the financial condition of company for conducting the analysis.

6

CHAPTER II

LITERATURE REVIEW

II.1. Financial Reporting

II.1.1 Definition of Financial Reporting

Financial Reporting is an important thing for the company because it shows the

company’s transaction that will be useful for the users to evaluate the company’s

financial performance within certain period. The definitions of financial reporting

below are opinions from the experts, such as

Definition from Horngren, Harrison:

“Financial Reporting is defined as a picture of the company in financial terms.

Financial reporting relates to a specific date or covers a particular period. It

summarizes the transaction data into a form that’s useful for decision making”

(2004, p.18)

Definition from Horngren, Harrison, and Oliver:

“Financial Reporting is a summary of financial transaction that occurred during

financial year concerned” (2009, p.48)

Based on the explanation above, it summarizes that Financial Reporting is the

report created by the accountant that summarizes the whole transactions of company

within certain period and provides useful information for the users regarding financial

condition of the company.

II.1.2 Type of Financial Reporting

According to Spiceland, Sepe, and Tomassini (2004, p.86), Financial Reporting

of a company is consists of five types of report and it stated in the below:

7

1) Statement of Comprehensive Income

Statement of Comprehensive Income is a change statement that

summarizes the profit-generating transaction that caused shareholders’ equity

(retained earnings) to change during the period.

2) Statement of Financial Position

Statement of Financial Position is a position statement that presents an

organized list of assets, liabilities, and equity at a particular point in time. On the

left side of balance sheet describes the company’s assets, whereas on the right

side describes company’s liabilities and equity of company.

3) Statement of Changes in Equity

The Statement of Owner’s Equity discloses the source of changes in the

permanent shareholders’ equity accounts. The increase in owner’s equity comes

from net income and the decreases in owner’s equity come from net loss and

withdrawals.

4) Statement of Cash Flows

The statement of cash flows summarizes the transaction that caused cash

to change during the period. It reports the cash coming in (cash receipt) and the

cash going out (cash payments) during a period

5) Notes Financial Statement

It is additional information provided in Financial Reporting that informs

the details of items stated in Statement of Comprehensive Income, Statement of

Financial Position, Statement of Changes in Equity and Statement of Cash

Flows.

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II.1.3 Objective of Financial Reporting

The accountants create the Financial Reporting of company for several

objectives. Spiceland, Sepe, and Tomassini (2004, p.19) explained the three basic

financial reporting objectives according to Statements of Financial Accounting

Concepts (SFAC) No. 1, as follows:

1) Financial reporting should provide information that is useful to present and

potential investors and creditors and other users, in making rational investment,

credit and similar decisions.

2) Financial reporting should provide information to help present and potential

investors and creditors and other users to assess the amounts, timing, and

uncertainty of prospective cash receipts.

3) Financial reporting should provide information about the economic resources of

an enterprise, the claims to those resources (obligations), and the effect of

transactions or events and circumstances that cause changes in resources and

claims to those resources.

II.1.4 Financial Reporting Users

According to the objective of financial reporting, it offers useful information for

the users about the company’s circumstances such as financial condition of company in

certain period and users who need information from Financial Reporting are:

1) Manager of the Company

The manager needs the financial reporting for acquiring information

about the financial position that will use as a basic consideration for making

decision to improve the company’s performance in the future.

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2) Shareholders

The shareholders need information from financial reporting to know the

company’s achievement in generating more profit. They need the report to

ensure whether the money that being invested has used effectively or not.

Moreover, the report provides an overview for them how much return that will

receive from the profit that company generated.

3) Creditors

For the creditors, financial reporting describes the company’s financial

condition or company’s ability to cover the interest and company’s liabilities.

4) Investors

The investors need to know the condition of financial reporting as a basic

of consideration for investment decision to decide whether to invest or not.

5) Governments

In this case, the financial reporting used as a basic to determine how

much tax that will be imposed for profit earned by the company.

II.2 Performance Measurement

Performance measurement means measuring the company’s operations or

activities for certain period to obtain the information about the implementation of

company’s program. An organization’s performance is measured based on its goal and

objectives. Performance measurement or evaluation is very important for the users of

Financial Reporting because it impacts on goal congruence, motivation, and employee

effort. An organization achieves the goal congruence when employees working in their

own perceived best interest, make decision that help meet the overall goals of the

organization. Employee effort is an exertion toward a goal or objective, it accompanies

goal congruence. Effort here not merely working harder or faster but also working

10

better. It concludes all conscious actions that result in more efficiency and effectiveness.

Whereas motivation is enthusiasm that can creates effort and action toward the

company’s goal. The managers are usually motivated to make decisions that will help to

achieve management’s expectation. For additional motivation, upper management may

offers bonuses to unit managers who meet or exceed performance targets.

II.3 Measuring the Financial Performance of Company

According to Horngren, Sundem and Stratton (2005), in measuring the

company’s performance, “managers can express some of these performance

measurements in financial term such as operating budgets, profit targets, or required

return on investments.” (p. 385). The managers use performance measurement to

monitor the achievements of an organization. The managers must consider several items

to evaluate the company’s performance such as company’s income and invested capital

that used to generate the income. There are several methods used to evaluate the

performance of company and some of them are return on investment, residual income

and economic value added. These methods incorporate both its asset as invested capital

and its operating income that is showed in figure-2.1:

Figure-2.1: Performance Measurement

Summary Performance Measures:

These three measures take into consideration:

1. Operating Income

2. Asset

Return on Investment Residual Income Economic Value Added

Source: Horngren, Sundem and Stratton (2005: p. 1220)

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II.3.1 Return on Investment (ROI)

II.3.1.1 Definition of return on investment

Return on investment is a part of financial ratio that often used by the people or

managers to measure the performance of company. There are several opinions from the

expert people who explain about the return on investment, namely:

Definition from Garrison and Noreen:

“Return on investment is the rate of return that investment centers managers able to

generate from their assets” (2003, p.542)

Definition from Keown, Martin, Petty, and Scot:

“Return on investment indicates the effectiveness of management at generating

profits on the firm’s assets, as measured by operating profits relative to the total

assets” (2005, p.77)

According to the definition above, it indicates that the return on investment is a

profitability ratio that measures the firm’s overall effectiveness by showing the income

as a percentage of the average total asset available to generate the profit.

Return on investment can be separated into two important ratios, profit margin

and total asset turnover.

a) Operating Profit Margin

Opinion from Keown, Martin, Petty, and Scot:

“Profit margin indicates the management’s effectiveness in managing the

firm’s income to measure the amount of operating income achieved per sales

dollar” (2005, p.78)

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Opinion from Spiceland, Sepe, Tomassini:

“Operating profit margin is operating income divided by net sales. The ratio

indicates the portion of each dollar of revenue that is available to withstand

either higher expenses or lower revenues” (2004, p.248)

From the definition above, it shows that the operating profit margin is a ratio

that measure how much profit earned by the company from each dollar sales.

The operating profit margin equation:

Operating Profit Margin = 𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆

𝑺𝒂𝒍𝒆𝒔

or more completely,

Operating Profit Margin = Sales – Cost of Goods Sold – General and

Administrative Expense – Marketing Expense

Sales

The researcher uses the company’s operating profit rather than net

income to determine the profit margin because the operating profit measures the

profit received from the operating activities. It is calculated before the cost of

the company’s financing policies such as interest expense. The operating profit

margin’s equation shows the factors affect to the company’s operating profit

margin and according to Keown, Martin, Petty, and Scot (2005, p.78) factors

affect to the operating profit margin are:

1) The number of units of product sold

2) The selling price for each product unit

3) The cost of manufacturing or acquiring the firm’s product

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4) The ability to control general and administrative expense

5) The ability to control expenses in marketing the firm’s product

The operating profit margin also indicates the management’s ability in

controlling the expenses such as cost of manufacturing, general and

administrative expense, and marketing expenses relative to the company’s sales.

The higher operating profit margin means the company is more effective in

managing the cost and expenses that related to the company’s sales. In contrary,

if the operating profit margin ratio is lower means the company is ineffective to

control its cost and expenses that related to the sales.

b) Total Asset Turnover

Opinion from Keown, Martin, Petty, and Scot:

“Total asset turnover is indicates management’s effectiveness at utilizing its

entire asset in generating sales” (2005, p.78)

Opinion from Spiceland, Sepe, Tomassini:

“Total assets turnover is computed by dividing a company’s net sales or

revenues by the average of total assets available for use during a period. The

total assets turnover ratio provides an indication of how efficiently a company

utilizes all of its assets to generate revenue” (2004, p.248)

According to the explanation above, the total assets turnover is a ratio

that measures the efficiency of company in managing its entire assets for

generating the sales. It indicated by the amount of sales generated per one dollar

of asset. The total assets turnover equation:

Total assets turnover = 𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕

14

The equation shows the relationship between company’s sales with the

average total assets which determined by adding the beginning and ending total

assets and dividing by two. The higher total assets turnover of company

indicates that the company is using its entire assets effectively to generate sales

but the lower total assets turnover of company indicates that the company is

ineffective to manage its entire assets in generating sales. The lower total assets

turnover may indicate a problem with one or more of assets elements. Thus, the

company must maintain its assets such as maintain its condition in order to

support the company’s operation to increase its sales. Spiceland, Sepe,

Tomassini (2004) argue that “some industries are characterized by low turnover

but typically make up for it with higher profit margins. Others have low profit

margins but compensate with high turnover. Grocery stores typically have

relatively low profit margins but relatively high assets turnover. In comparison,

a manufacturer of specialized equipment will have a higher profit margin but a

lower assets turnover ratio. But, this ratio is best evaluated in conjunction with

profit margin on sales.” (p. 248).

There are several factors affected to the company’s total assets turnover

as examined by Keown, Martin, Petty, and Scot (2005, p.79), which are the

turnover ratios for the primary assets held by the firm as mentioned below:

1) Account receivable turnover ratio

Account receivable turnover ratio indicates how rapidly the company is

collecting its credit. The higher account receivable turnover ratio of a company

means the company is faster at collecting its credit. In contrary, the lower

account receivable turnover ratio of a company means the company is slower at

collecting its credit.

15

The account receivable turnover equation:

Account receivable turnover = 𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆

The account receivable turnover ratio is related to the average collection

period. This ratio measure the how rapidly a firm is collecting its credit, as

measured by the number of days it takes to collect its account receivable.

The average collection period equation:

Average collection period = 𝟑𝟔𝟓

𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐

The more days required by company to collect its receivable means the

slower company to obtain the money and in contrary, the fewer days required by

company to collect its receivable means the faster company to obtain the money.

The account receivable turnover and average collection period provide useful

information for the company.

2) Inventory turnover ratio

Inventory turnover ratio is a ratio measures a company’s efficiency in

managing its investment in inventory or a ratio indicates the relative liquidity of

inventories. The higher ratio of company’s inventory turnover means the

company managing its inventory efficiently to generate the sales but it may

indicate the stock outs and lost sales in the future. Meanwhile, the lower ratio of

company’s inventory turnover means the company is inefficiency in managing

its inventory to generate the sales and it may result of overstocking and obsolete

inventory. The inventory turnover ratio equation:

Inventory turnover ratio = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

16

Same as account receivable turnover ratio, the inventory turnover ratio is

also relative to the average days in inventory. It measures the number of days

takes to sell the inventory or how often the company uses its inventory to

generate the sales as measured by dividing the inventory turnover ratio into the

number of days.

The average days in inventory equation:

Average days in inventory = 𝟑𝟔𝟓

𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐

The more days required for the company to sell its inventory means the

company uses its inventory infrequently to generate the sales. Moreover, the

fewer days required for the company to sell its inventory means the company

uses its inventory frequently to generate the sales. In relatively to the inventory’s

liquidity, the higher inventory turnover ratio indicates that the company has

liquid inventory that will enhance its ability to cover the company’s current

liabilities.

3) Fixed assets turnover ratio

Fixed assets turnover ratio measures the efficiency of company to

generate sales with its fixed assets such as plant and equipment. The company

must use its fixed assets well to generate sales because fixed assets such as

property, plant, and equipment are expensive to buy and maintain. The fixed

assets turnover ratio can be measured by dividing sales with the fixed assets.

The Fixed assets turnover ratio equation:

Fixed assets turnover ratio = 𝑺𝒂𝒍𝒆𝒔

𝑵𝒆𝒕 𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔

17

The higher ratio of fixed assets turnover means the company has used its

fixed assets well to generate the sales but it may indicates that company’s fixed

assets such as equipment is probably breaking down because it operates over

capacity. Whereas, the lower ratio of fixed assets turnover means the company

has used its fixed assets unwell or inefficient to generate the sales and it may

indicates that company operates in low capacity and company’s plant and

equipment is likely sitting idle.

According to the explanation of profit margin and total assets turnover, Garrison

and Noreen (2003, p.542) summarize the relationship between profit margin, total assets

turnover and return on investment in the equation of return on investment below:

These two ratios shown as formula of return on investment:

ROI = (𝑷𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏) X (𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓)

or more completely,

ROI = 𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆

𝑺𝒂𝒍𝒆𝒔 X

𝑺𝒂𝒍𝒆𝒔𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕

ROI equation is:

ROI = 𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕

Key measure of return on investment:

1) The higher return on investment the better company’s performance

2) The lower return on investment the worse company’s performance

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II.3.1.2 Methods Used to Increase ROI

There are several methods or ways to increase the company’s return on

investment and Garrison and Noreen (2003, p.550) proposed three basic ways to

increase the return on investment:

1) Increase sales

Change in sales can affect both profit margin and total asset turnover

because it appears as the denominator in profit margin computation and as the

numerator in total asset turnover computation. A change in sales can affect the

profit margin if expenses increase or decrease at a different rate than sales.

Further, a change in sales can affect the total asset turnover if sales either

increase or decrease without a proportionate increase or decrease in the

operating expense.

2) Reduce Expense

One solution to increase the company’s profitability and to stronger the

return on investment figure is through controlling the company’s expenses. The

managers may reduce the expenses through eliminating the total assets used in

investment.

3) Reduce total assets

Managers must realize that an excessive investment in total assets will

reduce total asset turnover and it affect directly to the return on investment. The

investment centre manager can control the total assets by eliminate the unneeded

inventories. Another approach is by reducing the account receivable through

considering the customer’s payment ability to provide receivable to them.

The diagram that appears in figure-2 helps managers to understand how

they can control the return on investment.

19

Figure-2.2: Elements of Return on Investment

Sales

:

Net Income

COGS

:

Profit Margin

Operating Expenses

Expenses

Sales

Other Expenses

Sales

X

ROI

Cash

Account Receivable

Current Assets

Inventories

:

Total Asset Turnover

Other current assets

+

Average Total Asset

Plant and Equipment

Other assets

Non-Current Assets

Source: Garrison and Noreen (1997: p.529)

II.3.1.3 Advantages and Disadvantages of Return on Investment Ratio

Advantages:

1) Return on investment formula provides clear understanding for the managers in

evaluating the performance of management’s effectiveness in utilizing the asset

to generate profit.

2) Return on investment as consideration for the managers in decision making,

what investments are most profitable that should be taken.

3) Return on investment as controller, because it encourages the manager to control

the investment through managing the numerator and denominator of the

equation (margin and assets) for the company.

20

Disadvantages:

1) In practice, the managers may not understand enough how to increase the return

on investment. They may take actions to increase the return on investment in the

short run but it has bad impact for the company in the long run such as suffer a

financial loss.

2) Mostly, the managers tend to focus on profit margin rather than total asset

turnover in maintaining the return on investment. It because the margin is can be

a valuable indicator of manager’s performance.

3) Managers who evaluated the performance based on return on investment focus

on income as a percentage of investment. Thus, they may reject investment

opportunities that may profitable for the whole company but having lower

percentage in return on investment.

4) The managers need others data or information such as the past return on

investment information or the return of other firms in industry to make

comparison and make a decision regarding to the investment.

II.3.2 Residual Income

II.3.2.1 Definition of Residual Income

There are several people opinions who explain about residual income as

performance measurement, such as:

Definition from Atkinson, Kaplan, Matsumura and Young:

“Residual income equals reported accounting income less the economic cost of the

investment used to generate that income” (2007, p.606)

21

Definition from Horngren, Harrison and Oliver:

“Residual income measures the division’s profitability and the efficiency with which

the division uses its asset” (2009, p.1223)

According to the definition above, it summarized that residual income is income

earned by the investment centre above minimum required return on investment. Under

the residual income criterion, managers are asked to do whatever they think is necessary

to make residual income as large as possible.

Residual income also incorporates another piece of information such as

management’s target rate of return. The target rate of return is the minimum acceptable

rate of return that top management expects to earn with its assets. Residual income

compares the company’s operating income with the minimum income expected by

management’s given the size of the division’s assets. The residual income equation:

Residual Income = Operating Income – Minimum acceptable income

In this equation, the minimum acceptable income is defined as management’s

target rate of return multiplied by the total assets. Therefore,

Residual Income = Operating Income – (Target rate of return X Average Asset)

Key measure of residual income calculation:

1) Residual income > 0, means positive residual income

A positive result of residual income calculation means that the operating income

exceeds management’s target rate of return.

2) Residual income < 0, means negative residual income

A negative result of residual income calculation means the company does not

meet the management’s target rate of return.

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3) Residual income = 0

If residual income result is equals zero (0), it means the company just able to

meet the management’s target rate of return.

In practice, the residual income concept is almost same as economic value added

(EVA). It is because the minimum or target rate of return required by the managers

refers to the cost of capital or weight average cost of capital (WACC). Horngren,

Sundem and Stratton (2005), defined residual income as “after-tax operating income

less a capital charge.” (p.433) In this case, the cost of capital is considered as the

minimum level of return that must be earned by the company to meet investor’s

expectation and each company has its own consideration to determine the target rate of

return.

II.3.2.2 Advantages and Disadvantages of Residual Income

Advantages:

1) Residual income focus on the dollar amount of income rather than a percentage.

Thus, it encourages managers to consider new investment that may profitable for

the entire company but that would be rejected by managers who are evaluated

by the return on investment formula.

2) Residual income method will promote goal congruence and lead to better

decision than using return on investment in evaluate the company’s

performance. The goal congruence is achieved because the managers will take

an action that top management desires.

3) The management may set different target rate of return for different investments,

the riskier investment or business environment the higher target rate of return.

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Disadvantages:

1) Residual income method cannot be used to compare the performance of

divisions of different sizes on investment.

2) In Residual income method, the managers are difficult to estimate or determine

the minimum return or target rate of return.

II.3.3 Economic Value Added (EVA)

II.3.3.1 Definition of Economic Value Added (EVA)

There are several arguments from the expert people who define the economic

value added, namely:

Definition from Harrison and Horngren:

“Economic Value Added is a method used to evaluate the company’s performance

which combines the concept accounting income and corporate finance to measure

whether the company’s operations have increased stockholder wealth” (2004, p.631)

Definition from Brigham & Houston:

“Economic Value Added as economic profit estimation of the business for the certain

period and it is different from accounting profit. In short, economic value added is

residual income measurement that subtracting the cost of capital to operating

income” (2007, p.68)

Definition from Horngren, Harrison and Oliver:

“Economic Value Added as a type of residual income calculation that focuses on the

income (in excess of expectation) for two specific stakeholders, investors and long-

term creditors” (2009, p.1224)

Thus, these definition show that economic value added is a method used to

evaluate the company’s performance by considering the investors and creditors desire

24

through subtracting the net operating income to the cost of capital. Since these

stakeholders provide the company’s capital, management often wishes to evaluate how

efficiently they using its assets from these two stockholder’s viewpoints. The Economic

Value Added (EVA) equation:

EVA = NOPAT – Capital Charge

II.3.3.2 Procedures to calculate EVA

According to Lilis (2011, p.7) there are five procedures that must be completed

to determine economic value added, which are:

1) Determine NOPAT (Net Operating Profit After Tax)

NOPAT = Net Operating Income x (1-Tax)

If the company deducts any interest expense to compute the operating

income, it means the company must be added back interest expense to its

after-tax operating income. Changes in company’s NOPAT will

influence the economic value added result because the lower NOPAT

earned by the company will give negative impact for the company

because it may reduce the economic value added of company.

Conversely, the higher NOPAT will give positive impact for the

company because it may increase its economic value added.

2) Determine Invested Capital

Invested Capital = Average Asset – Current Liabilities

Invested capital is the amount of money that has been spent by the

company for making an investment. Economic Value Added (EVA)

determines investment by deducting total asset to current liabilities

because funds owed to short-term creditors, such as suppliers (account

payable) and employees (wages payable), will be paid in the immediate

25

future and will not be available for generating income in the long run.

The managers are not expected to earn a return for investors and long-

term creditors on those funds that will soon be paid out to short-term

creditors.

3) Determine Weight Average Cost of Capital (WACC)

WACC = wdkd(1-T) + wpkp + wcks

4) Determine Capital Charge

Capital Charge = Invested Capital x WACC

Capital charge is the dollar amount of company’s cost of capital that

must be paid by the company for using the funds from investors and

creditors. The capital charge is determined by multiplying the invested

capital and the rate of company’s cost of capital or WACC. The

fluctuation in capital charge will influence the company’s economic

value added. The higher capital charge will affect to the negative

economic value added and in contrary, the lower capital charge will

affect to the positive economic value added.

5) Determine EVA

EVA = NOPAT - Capital Charge

Key measure of economic value added (EVA):

1) EVA > 0 = positive EVA

A positive EVA means the company has economic value because the income

earned is higher than cost of capital. Thus, the income earned is not only able to

cover the cost of capital which derives from the investors and creditors, but it

also provides additional capital for company’s operation.

26

2) EVA = 0

If EVA result equals zero (0), it means the company just meets the break even

point where the income earned just cover the cost of capital.

3) EVA < 0 = negative EVA

A negative EVA means the company has no economic value because the income

earned is lower than cost of capital. In this case, the income earned is unable to

cover the cost of capital which derives from the investors and creditors and even

unable to provide additional capital for company’s operation.

II.3.3.3 Advantages and Disadvantages of Economic Value Added

Advantages:

1) EVA promotes goal congruence, just as residual income, because EVA looks at

the income generated in excess of expectation, solely from the perspective of

investors and long-term creditors.

2) Economic Value Added encourages managers to distribute management bonus

for the company’s employee. Thus, it encourages the people to be efficient,

productive, and proactive in thinking about the customers.

3) EVA encourages the managers to behave like the owners. According to Keown,

Martin, Petty and Scott (2005) “when managers become owners, they begin to

think a lot harder about taking money out of mature business and investing in

growth areas.” (p.449)

4) EVA does not need other data or information such as EVA of company in the

past or other firm’s EVA to make comparison and make a decision regarding to

the investment.

Disadvantages:

27

1) The cost of capital calculation is more difficult because the manager needs

additional data related to the cost of common equity such as market price of

stock, interest rate, market return and return on equity.

2) Economic value added (EVA) just provides the overview of company’s

economic value in certain period.

II.4 Cost of Capital

II.4.1 Definition of Cost of Capital

Cost of capital is one aspect that must be considered in calculating economic

value added. A firm’s overall cost of capital is an average of the cost of the various

types of funds that used or called as Weight Average Cost of Capital (WACC). Soffer

(2003) defined Weight Average Cost of Capital (WACC) as “the weighted average of

the after-tax cost of debt and cost of equity. The weighting for debt is the proportion of

debt to total capital, whereas the weighting for equity is the proportion of equity to total

equity.” (p. 155). According to researcher’s viewpoint, Weight Average Cost of Capital

(WACC) is weight average of the component costs of debt, preferred stock, and

common equity. The formula for calculating Weight Average Cost of Capital (WACC):

WACC = wdkd(1-T) + wpkp + wcks

Where:

wd = portion or percentage of Debt

kd = After-tax component cost of debt

wp = portion or percentage of preferred stock

kp = component cost of preferred stock

wc = portion or percentage of common equity

28

ks = component cost of common equity. It rises by retaining earnings or internal

equity and external equity which rise by issuing new stock.

T = Tax

In calculating Weight Average Cost of Capital (WACC), the researcher must

elaborate the two items which is capital components and cost of each capital

component.

a) Capital component

It describes the types of capital used by firms to raise funds. The overview of

types of capital used is shown by figure-2.3 below. Debt is type of capital

acquired by issuing bonds or borrowing money from financial institution such as

bank. Some companies are also financed by preferred stock which is the stock

that bought by the investors to earn fixed dividend. The third type of capital is

common equity that is provided by the company’s common stockholders and it

is raise in two ways:

1) By issuing new common stock and

2) By retaining earnings (that is, by not paying out all of their earnings as dividend)

Equity raised by selling newly issued stock is called as externally equity,

while retained earnings, capital earned by profitable operation, are called

internal equity. The types of capital are showed in figure-2.3 below:

29

Figure-2.3: Types of Capital

Source: Keown, Martin, Petty, and Scot (2005: p. 330)

b) Cost of Capital

After calculating the capital components of the company, then the managers

must determine the cost of capital for each capital components. Garrison and

Noreen (2003) explained Cost of Capital (COC) as “the average rate of return

the company must pay to its long-term creditors and to shareholders for the use

of their funds. The cost of capital is the minimum required rate of return because

if a project’s rate of return is less than cost of capital, the company does not earn

enough to compensate its creditors and shareholders. Therefore, any project with

a rate of return less than cost of capital should not be accepted.”(p. 641).

According to Keown, Martin, Petty, and Scot (2005) cost of capital is

“an average of the costs of the various types of funds it uses. The cost of capital

is calculated as a weight average of various types of funds used over time,

regardless of the specific financing used to fund projects in a given year.”

(p.330). The cost of capital for each capital components are:

1) After-Tax Cost of debt

Cost of debt is a cost which reflects to the interest rate that must be paid

by the company for its debt such as bank loans or bonds. Whereas after-

Types of Capital

Debt

Preferred Stock

Common Equity

New Common Stock

Retained Earnings

30

tax cost of debt is the true cost of debt because it considers the tax rate as

expense that must be paid by the company.

The formula is:

After-tax cost of debt = kd(1-T)

2) Cost of Preferred Stock

It is the rate of return investors required on the firm’s preferred stock.

The formula for calculating cost of preferred stock is:

Cost of Preferred Stock = kp = 𝑫𝑷

Where:

D = Preferred Dividend

P = Stock Price of preferred stock

3) Cost of Common Equity

Cost of common equity is based on the rate of return investor required on

the company’s common stock. The common equity is raised in two

ways, by retaining some of the current year’s earnings and by issuing

new common stock.

a) Cost of Retained Earnings is rate of return required by stockholders on a

firm’s common stock. There are three methods in determining the cost

of retained earnings:

1. Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is a relationship between

expected returns and risk in which risk is captured by the systematic risk

(beta). The expected return is equal to the sum of risk-free-rate of

interest and a risk premium equal to the product of beta and the market

risk premium.

31

The equation is:

ke = krf + (kpm) ß

Where, krp = km – krf

Therefore,

ke = krf + (km – krf) ß

Where:

ke = required rate of return ß = beta

krf = risk-free return krp = risk premium

km = expected return for the

market

From the formula above, it shows that there are some

components that must be considered which are risk-free return, market

return and beta. Risk free-return is the rate of return of an investment

with no risk of financial loss and market return is the return on the

overall theoretical market portfolio includes all assets and having the

portfolio weighted for value. Meanwhile, beta is measuring the

relationship between an investment's returns and the market's return. It is

a measure of the investment's non-diversifiable risk.

According to Young and O’Byerne (2001, p.154), there are two

components that must be computed which are stock return and market

return in determining systematic risk (ß). These components are

calculated by using formula below:

32

Stock return

ki = (𝑷𝒕 – 𝑷𝒕−𝟏)𝑷𝒕−𝟏

ki = stock return

Pt = Stock price at Period t

Pt-1 = Stock price at Period t-1

Market return

km = (𝑰𝑯𝑺𝑮𝒕 – 𝑰𝑯𝑺𝑮𝒕−𝟏)𝑰𝑯𝑺𝑮𝒕−𝟏

km = market return

IHSGt = IHSG at Period t

IHSGt-1 = IHSG at Period t-1

From those components, the beta (ß) equation is:

ß = 𝑪𝒐𝒗 (𝑲𝒊,𝑲𝒎)𝑽𝒂𝒓 (𝑲𝒎)

2. Dividend-Yield-plus-Growth-Rate or Discounted Cash Flow

Dividend-Yield-plus-Growth-Rate or (DCF) Discounted Cash

Flow is an approach in which the investors expect to receive a dividend

yield plus capital gain for a total expected rate of return.

The DFC equation is:

ke = 𝑫𝟏𝑷𝒐

+ 𝒈

where,

g = r x ROE and r = 1 - 𝑫𝑬𝑷𝑺

Then formula is:

ke = 𝑫𝟏𝑷𝒐

+ 1- 𝑫𝑬𝑷𝑺

𝒙 𝑹𝑶𝑬

33

Where:

ke = cost of retained earnings g = growth rate

D1 = dividend r = retention rate

Po = stock price

ROE = return on equity

3. Bond-Yield-plus-Risk-Premium

Bond-Yield-plus-Risk-Premium is an approach used by managers

to determine the cost of retained earnings through adding the risk

premium to the interest rate on the firm’s own long-term debt to estimate

its cost of equity.

The equation of Bond-Yield-plus-Risk-Premium is:

ke = Bond yield + risk premium

b) Cost of New Common Stock

Cost of New Common Stock is cost raised by issuing stock has a

somewhat higher cost than equity raised as retained earnings due to the flotation

cost (the percentage cost of issuing new common stock) involved with new

stock issues. The equation is:

ke = 𝑫𝟏𝑷𝒐 (𝟏−𝑭)

+ 𝒈

Where:

ke = cost of new common stock g = growth rate

D1 = dividend F = flotation cost

Po = stock price

34

II.4.2 Factors That Affect the WACC

The cost of capital is affected by number of factors. Some are beyond a

firm’s control and Keown, Martin, Petty, and Scot (2005, p.344) write some

ways that a firm can directly affect its cost of capital in primary ways:

1) By changing its capital structure

If a firm changes its target capital structure, then the weights used to

calculate the WACC will change. An increase in the use of debt will increase the

financial risk which is the additional risk placed on the common stockholders as

a result of the decision to finance with debt. It rises by the interest rate that must

be paid by the company for using debt. Conversely, a decrease in the use of debt

will increase the business risk which is the riskiness inherent in the firm’s

operation if it uses no debt.

2) By altering its capital budgeting decisions

The firm’s capital budgeting decision can also affect its cost of capital.

When a firm estimates the cost of capital, it uses as the starting point the

required rate of return on the firm’s outstanding stock and bonds. If the firm

decides to invest in an entirely new and risky line of business then the WACC

will increase. Thus, the riskier investment means the higher required capital and

the higher WACC.

3) By changing the dividend payout

Dividend policy affects the amount of retained earnings available to the firm,

and the possible need to sell new stock and thus incur flotation cost. This

suggests that the higher the dividend payout ratio, the smaller the addition to the

retained earnings and the higher the cost of equity and WACC. However,

investors may want the firm to pay out more dividends, and thus the reduction in

the payout ratio might lead to increase in the required rate of return of equity.

35

II.5 Research Framework

According to the theoretical which has explained above, the researcher creates

the research framework which describes the topic that will be discussed in this research

which is analyzing the company’s financial performance using return on investment

(ROI), residual income (RI) and economic value added (EVA). The research framework

facilitates the readers to understand the concept of this research.

Figure-2.4: Research Framework

1. RI > 0 = Good Performance

2. RI < 0 = Bad Performance

1. EVA > 0 = Good Performance

2. EVA< 0 = Bad Performance

The higher ROI the better performance

Economic Value Added

Residual Income Return on Investment

Technique Analytical

1. Statement of Financial Position

2. Statement of Comprehensive Income

3. BI rate

4. Jakarta Composite Index

5. Company’s Stock Price

PT X

36

CHAPTER III

METHOD OF DATA PROCESSING

AND COMPANY’S EXISTING CONDITION

III.1 Method of Data Processing

III.1.1 Types and Data Resources

The research method applies for this study is qualitative method where the

researcher is doing direct observation or field research to obtain the primary data.

Primary data means obtains the data directly from the research object or company that

being observed without intermediary. In this research, the researcher is going to discuss

about performance evaluation of PT X during three periods. Thus, the researcher

requires data that relative to the company’s performance to support the study and for

analysis purpose.

III.1.2 Data Collection Method

In this research, the researcher is going to evaluate and discuss about the

performance of PT X by using return on investment, residual income and economic

value added. Therefore, the researcher requires some data such as statement of financial

position and statement of comprehensive income of company. Then, there are several

methods used by the researcher to gather the required data such as:

1) Documentation

The documentation means collects and examines the documents related to

variable or information to supports the research. For this research, the researcher

needs Financial Reporting of PT X and company’s organization structure.

37

2) Inquires of the client

In this research, the researcher has some interviews with the finance and

accounting staff of PT X to acquire more information regarding to the research

problem to support the analysis. Interviews and discussion are held by

researcher through direct talks with the competent people related to the

company’s performance.

III.1.3 Data Processing Method

When the data has been collected, then it must be processed to evaluate the

performance of company. The procedures need to be completed by the researcher in

processing the data are:

1) Analyze the data

The researcher analyzes the fluctuation in each significant account in statement

of financial position and statement of comprehensive income.

2) Compute the return on investment

In computing the return on investment, there are some procedures need to be

completed such as:

a) Provide required data for calculating return on investment such as:

Net operating income of PT X in 2009, 2010 and 2011

Net sales of PT X in 2009, 2010 and 2011

Total assets of PT X in 2009, 2010 and 2011

b) Compute the company’s operating profit margin for each period

c) Compute the average total assets in 2009, 2010 and 2011 as component

in total asset turnover.

d) Compute the total assets turnover ratio

e) Compute return on investment of PT X for 2009, 2010 and 2011

38

3) Compute Residual Income

The procedures to calculate the residual income are:

a) Provide required data for calculating residual income such as:

Net operating profit of PT X in 2009, 2010 and 2011

Target rate of return of PT X in 2009, 2010 and 2011

Total assets of company in 2009, 2010 and 2011

b) Compute the minimum required return

c) Compute the residual income of company

4) Compute Economic Value Added

The procedures to calculate the Economic Value Added are:

a) Provide required data for calculating economic value added such as:

Net operating profit of company in 2009, 2010 and 2011

The company’s tax rate in 2009, 2010 and 2011

The company’s total assets in 2009, 2010 and 2011

The company’s current liabilities in 2009, 2010 and 2011

The company’s long-term liability in 2009, 2010 and 2011

The company’s total equity in 2009, 2010 and 2011

b) Compute the NOPAT or Net Operating Profit After Tax.

c) Compute the invested capital

d) Compute the portion of debt

e) Compute the cost of debt

f) Compute the portion of equity

g) Compute the cost of equity

h) Compute WACC or Weight Average Cost of Capital

i) Compute the capital charge

j) Compute economic value added of company.

39

5) Analyze the measurement result from each calculation to evaluate the financial

performance of company

6) Comparing the performance of company that measured by each method

7) Make conclusions for company to improve the performance

The procedures required in processing the data to obtain useful information are

represented in the framework below:

Figure-3.1: Procedures in processing data

Analyze the data

Compute Return on Investment

Conclusion

Comparing the Company’s Performance

Compute Residual Income

Compute Economic Value Added

Analyze the Measurement Result

40

III.2 Company’s Existing Condition

III.2.1 Profile of PT X

PT X is a limited liability Company which established in Cikarang on May 29,

2008. The company was founded by the businessman who came from Korea and he as a

founder of PT X has more than 90% of company’s shares. The company is domiciled in

Cikarang and its factory is located in Cibitung. The company’s office is located at

Jababeka Industrial Area II, Jl. Industri Selatan 8 Block EE 6M, Cikarang whereas the

company’s factory is located at MM 2100 Industrial Area Block G, Cibitung.

PT X is a part of Merchandise Company which buys the goods and then resells

it to the customers. The main activity of company is distributing the electronic

component which is devices or tools that is used to affect electrons and the device is

often used as an important part of electronic products. The company’s customers are

companies whose produce the electronic products such as television, DVD, refrigerator

and other electronic products. Nowadays, the company has employed 190 employees

who assigned in two different places which are factory and office, for assisting

company in running the business.

III.2.2 The company’s objectives

The company’s objectives of PT X are mentioned below:

a) Caring for consumer needs by provide available quality goods for customers to

meet customer’s need and expectation.

b) Become the successful supplier by expanding the office and setting up trading

activities in Indonesia.

c) Increase company’s performance by increasing profits and strengthening

business relationships with clients.

41

III.2.3 Company’s Product

The company’s activity is selling varies electronic component to the customers

and it consists of:

1) Capacitors

It is an electronic component used to store energy and it is a part of electrical

circuit in many common electrical devices for example is for smoothing the

output of power supply and in electric power transmission systems, it is for

stabilizing voltage or power flow.

2) Thermistor

It is a semiconductor device which has function that related to the temperature.

Thermistor can be used to compensate for temperature variation in other

components of a circuit.

3) LED

A light-emitting diode (LED) is a semiconductor light source. LEDs are used as

indicator lamps in many devices and are increasingly used for other lighting for

example LED is used in applications as advertising and general lighting.

4) and others

III.2.4 Organization Structure of PT X

Organization structure is the system of job relationship that coordinates the

employees in order to achieve the company’s goals. It shows the rights, duties and

responsibilities of each department intercompany. The organization structure is a

communication tool that enables company in doing its business especially for the

company’s operation. In its operation, PT X has organization structure which consists

of several divisions such as finance division, marketing division and general affairs

division. These divisions are responsible to the superior for their duties that related to

the company’s activities and its organization structure is shown in the chart below:

42

Figure-3.2: Company’s Organization Structure

Source: PT X (Data Processed)

The general tasks or responsibilities of each department are explained below:

1) Company’s Director

The tasks or responsibilities of company’s director are:

a) Give the guidelines to the employees relative to the company’s operation

and goals.

b) Obtaining the information related to the existing condition of company

or company’s performance.

c) Sign the contract or important documents related to the company’s

activities.

d) Giving the task or duties to each department in a company and supervise

their activity.

e) And others responsibilities related to the company’s activities.

2) Finance Supervisor

The tasks or responsibilities of Financial Supervisor are:

a) Implement the company’s activities that related to the financial such as

selecting vendors, purchase the raw material and paying tax.

FINANCE SUPERVISOR

COMPANY’S DIRECTOR

GENERAL AFFAIRS SUPERVISOR

MARKETING SUPERVISOR

STAFF STAFF STAFF

43

b) Recording each company’s transactions that related to the company’s

financial.

c) Arrange the financial reporting of company for certain period and

evaluate the financial performance of company.

d) Prepare or create the company’s budgeting for the company’s

operational such as purchase the raw material, transportation expenses

and others expenses for the employee who assigned to deliver the

products to the customers.

e) And other tasks or responsibilities related to the company’s financial.

3) General Affairs Supervisor

The tasks or responsibilities of General Affair supervisor are:

a) Provide required stationery by each department and requested for

stationary usage reports to each department.

b) Perform administrative tasks to ensure that the staffs can work

efficiently, for example ensure that the equipment and machinery used in

their department must be in good working.

c) Provide mailing services or courier to support the company’s

operational.

d) Provide transportation to support company’s activities include

scheduling the cars operational and asking for reports of operational

expenses & kilometer distance.

e) And other duties or responsibilities of general affairs related to the

company’s administrative.

4) Marketing Supervisor

The tasks or responsibilities of marketing Supervisor are:

44

a) Keep promote the company’s products to the company which require the

electronic components to support its operation.

b) Increase the number of units of product sold to increase the company’s

revenue.

c) Create the strategies to promotes the company’s products and increase

sales.

d) And other task or responsibilities related to the product’s market.

5) Staff

The task or responsibility of company’s staff is assisting the supervisor

in their division to implement or complete the tasks or duties related to the job

description. Then, those tasks are must be accountable to their superior or

employer.

PT X is a company that still in the development stage therefore the company

does not have a manager in each division, but each division controlled by a supervisor.

There are only 2 until 3 people in each division who work in the office while the others

are about 180 employees working in the factory. Moreover there are some employees

who assigned as drivers and security guard.

45

CHAPTER IV

ANALYSIS AND EVALUATION

IV.1 Performance Measurement of PT X

Financial Reporting is a report created by the accountant to summarize the

whole transaction of company within certain period. It is important because it provides

some information related to the company’s financial such as how much capital invested

by the company to operate its business and how they allocate the company’s income.

Financial reporting is also defined as company’s accountability report toward its

investors for using their funds to support company’s operation especially for generating

profit. Nevertheless, it has no sufficient information that required by the users.

Therefore, the managers need performance measurement to measure the company’s

achievement and the manager’s effectiveness in running the business in certain period.

Performance measurement can be implemented by the managers by analyzing

the financial reporting for obtaining useful information. Generally, the managers

measure the company’s performance by computing the financial ratios or other

measurement methods that suitable with the management’s objective. Measuring the

company’s performance is very important because it reflects to the company’s

achievement and enables the decision makers in decision making for example to create

or change the strategies to increase sales and to make a new investment that have better

prospect for company’s development.

In accounting, there are five types of report in Financial Reporting. The reports

are Statement of Financial Position, Statement of Comprehensive Income, Statement of

Change in Equity, Statement of Cash Flow and Notes Financial Reporting. Those

reports are often used by the users to make a decision but in this research, the researcher

is only need Statement of Financial Position and Statement of Comprehensive Income

46

during three years to measure the company’s performance by calculating return on

investment, residual income and economic value added. The table below describes the

company’s financial condition for both, financial position and company’s income.

Table-4.1: Company’s Statement of Financial Position

Description 2009 2010 2011

Asset: Current Asset 35,002,337,001 40,791,832,108 17,288,516,882 Non-Current Asset 4,968,962,173 4,220,601,728 9,183,575,198

Total Asset 39,971,299,174 45,012,433,836 26,472,092,079 Liability:

Current Liability 26,471,111,472 35,687,596,399 18,010,248,871 Long-Term Liability 5,428,528,792 970,881,627 -

Total Liability 31,899,640,264 36,658,478,026 18,010,248,871 Total Equity 8,071,658,910 8,353,955,810 8,461,843,208

Total Liability and Equity 39,971,299,174 45,012,433,836 26,472,092,079 Source: Financial Reporting of PT X

Table-4.2: Company’s Statement of Comprehensive Income

Description 2009 2010 2011

Net Sales 102,585,357,923 235,280,028,188 260,091,168,572 Cost of Goods Sold 94,069,440,428 226,806,854,389 253,928,554,806 Operating Expenses 6,540,619,027 6,688,787,647 5,139,220,699

Operating Profit 1,975,298,468 1,784,386,153 1,023,393,067 Net Profit 240,778,616 345,417,719 107,887,398

Source: Financial Reporting of PT X

IV.2 Analyze Return on Investment

Return on investment is a part of profitability ratio that measures the company’s

performance by considering the operating profit earned from its operation and total

assets invested for generating profit. In computing the return on investment, there are

two ratios that must be considered, they are:

1) Operating profit margin ratio

Operating Profit margin ratio = 𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆

𝑺𝒂𝒍𝒆𝒔 x 100%

47

2009

Operating Profit margin ratio = 1,975,298,468 102,585,357,923

x 100% = 1.93%

2010

Operating Profit margin ratio =1,784,386,153235,280,028,188

x 100% = 0.76 %

2011

Operating Profit margin ratio =1,023,393,067260,091,168,572

x 100% = 0.39 %

Profit margin is a ratio that measures how much profit earned by the

company from its sales. These results show that in 2009, the company earns

profit of Rp0.0193 from selling the products. Whereas, the profit that is earned

by the company in 2010 and 2011 is decreasing because the company is only

earns profit of Rp0.0076 in 2010 and Rp0.0039 in 2011. Operating profit margin

shows the management’s ability in controlling the cost or expenses and the

result shows that in 2009 the managers are more effective to manage the

company’s cost that relative to sales rather than in 2010 and 2011.

1) Calculate the company’s total asset turnover ratio

Total asset turnover =𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕

2009

Total asset turnover =102,585,357,923

(38,172,590,711 + 39,971,299,174)÷ 2 = 2.63 times

2010

Total asset turnover =235,280,028,188

(39,971,299,174 + 45,012,433,836)÷ 2 = 5.54 times

48

2011

Total asset turnover =260,091,168,572

(45,012,433,836 + 26,472,092,079)÷ 2 =7.28 times

The calculation shows that the total asset turnover ratio in 2010 is higher

than ratio in 2009 but it is lower than ratio in 2011. In 2009, the company uses

its assets for 2.63 times to generate the sales and in 2010 the company uses its

asset for 5.54 times a year to generate the sales. Meanwhile, in 2011 the

company is more frequent to use its assets to increase its sales and it is around

7.28 times a year. Thus, the results indicate that in 2011 the company is more

efficient in using its assets to increase the sales. Indirectly, the higher total asset

turnover ratio may offer an indication that the company is more frequent to sell

the products.

In practice, any changes occurred in operating profit margin ratio and

total asset turnover ratio will influence the percentage of return on investment.

The higher ratios will affect to the higher return on investment and conversely,

the lower ratios will affect to the lower return on investment. The relation

between those ratios is represented by the calculation below:

ROI = (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏) X(𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓)

2009

ROI = 1.93% X 2.63 = 5.08 %

2010

ROI = 0.76 % X 5.54 = 4.21 %

2011

ROI = 0.39 % X 7.28 = 2.84 %

49

The ratios are summarized in the table below:

Table-4.3: Return on Investment

Description 2009 2010 2011

Operating Profit Margin 1.93% 0.76 % 0.39 %

Total Assets Turnover 2.63 times 5.54 times 7.28 times

ROI 5.08 % 4.21 % 2.84 % Source: Data Processed

Return on investment indicates how much profit that will be earned by the

company from each rupiah asset invested. The higher percentage of return on

investment would indicate the better performance of the company. The calculation

shows that the company’s return on investment in 2009 is 5.08% and it means the

company is able to generate profit for Rp0.0508 from each rupiah asset invested. In

2010 the return on investment is 4.21% which means the company is able to generate

profit for Rp0.0421 from each rupiah asset invested. Whereas in 2011, the ratio is

2.84% which indicate that the company is able to generate profit for Rp0.0284 from

each rupiah asset invested. Thus, by having higher percentage the performance of PT X

in 2009 is better than performance in 2010 and 2011. Meanwhile, the performance of

PT X in 2011 is worse because the manager is not effective to manage its assets in

generating the higher profit.

The return on investment is affected by the operating profit margin ratio and the

total assets turnover ratio. According to the result, the company’s operating profit

margin in 2009 is 1.93% and it decreased by 1.17% (0.76% - 1.93%) in 2010. It

decreases due to several reasons such as the company’s sales, cost of goods sold and

operating expenses. According to the Financial Reporting of PT X, the sales in 2010

increase significantly but it does not affect to the higher operating profit because the

cost and expense that relative to the sales are also increase. The sales in 2010 increased

50

by Rp132,694,670,265 (Rp235,280,028,188 – Rp102,585,357,923) and it indicates that

the marketing staff has promoted the product well. The cost of goods sold increased by

Rp132,737,413,961 (Rp226,806,854,389 – Rp94,069,440,428) and it occurred due to

increasing the cost of material and packaging. The higher cost of material means the

higher cost of product unit and it affects to the higher sales price per unit. Whereas, the

operating expense increased by 148,168,620 (Rp6,688,787,647 – Rp6,540,619,027)

because there is an increase in the travel expense.

Meanwhile, operating profit margin in 2011 decreased by 0.37% (0.39% -

0.76%) and it also caused by increasing in company’s the sales and cost of goods sold.

The cost of goods sold increased by Rp27,121,700,417 (Rp253.928.554.806 -

Rp226.806.854.389) or 11.96% from previous year whereas the sales just increased by

Rp24,811,140,384 (Rp260.091.168.572 - Rp235.280.028.188) or 10.55%. It shows that

the cost of goods sold has greater increase than its sales. These results reflect to the

company’s problem in managing its inventory which is overstocking inventory that

impact to the obsolete inventory that can reduces the product quality and sales price of

product but it is not reduce the cost of goods sold. Moreover, the higher sales and cost

of goods sold are influenced by the higher price of product acquisition, thus it

encourages the manager to set the higher cost and price for each product sold.

Another ratio affect to the return on investment is total assets turnover ratio. It

measures how often the company uses its entire assets to generate the sales that reflect

to the management’s effectiveness in managing its assets. According to the calculation,

the total assets turnover of company in 2010 increased by 2.91 (5.54 – 2.63) while in

2011 it increased by 1.74 (7.28 – 5.54). The total asset turnover in 2010 is increase

because the numerator and denominator have increased but the numerator has greater

increase rather than the denominator. The sales in 2010 increased by

Rp132,694,670,265 whereas the average total assets just increased by Rp3,419,921,563

51

(Rp42,491,866,505 – Rp39,071,944,943). The total asset increases due to increasing in

some categories of assets such as account receivable and inventories and indirectly, it

caused by increasing in company’s sales.

Meanwhile, the total assets turnover in 2011 has increased due to several

reasons that reduce some categories of assets. It caused by depreciation of company’s

fixed assets that reduce the value of its assets and it may indicate that the equipment has

been obsolete. Moreover, in 2011 the total asset decreases significantly because

company’s receivable has been collected for 20,208,769,120 (22,445,934,312 –

2,237,165,192). The decline in company’s receivable may indicates that in 2011 the

company is more effective in collecting its receivable and it can be examined by

computing the account receivable turnover ratio as follows:

Account receivable turnover ratio

Account receivable turnover = 𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆

Average collection period = 𝟑𝟔𝟓

𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐

a) 2009

Account receivable turnover = 102,585,357,923

( 19,915,771,963 + 20,854,211,480)÷2

= 5.03 times/year

Average collection period = 3655.03

= 72.53 days

b) 2010

Account receivable turnover = 235,280,028,188

(20,854,211,480 + 22,913,451,562)÷2

= 10.75 times/year

Average collection period = 36510.75

= 33.95 days

52

c) 2011

Account receivable turnover = 260,091,168,572

(22,913,451,562 + 2,237,165,192)÷2

= 20.68 times/year

Average collection period = 36520.68

= 17.65 days

According to the calculation, the account receivable turnover ratio in 2011 is

higher than ratio in 2010. It indicates that the company is more often at collecting its

credit and the average collection period indicates that the company collects its credit

rapidly. It means the company has ability to convert its account receivables into cash

sooner. A declined in average collection period and increase in account receivable

turnover ratio may indicate that the management of PT X has implemented its collection

policy as well. Moreover, the decline in the account receivable turnover and increase in

average collection period may indicate that the company is trying to maintain its

customers. It is important for the managers in order to attract the customer’s attention

because the company is only established.

Return on investment enables the managers in evaluating the performance of

company by considering the investment’s effectiveness. It is easy to be implemented by

the managers because the return on investment provides them an obvious overview how

much the potential profit that will be generated by the company from its investments.

According to the return on investment calculation above, it shows that investment in

2009 is the most profitable because it has better prospect by offering profit for

Rp1,975,298,468 or 5.08 % of total assets invested by the company. It means the

investment decision that has been made by the decision makers is effective. In other

words, the company’s performance in 2009 is better than performance in 2010 and 2011

because it has higher percentage of return on investment.

53

The managers who use the return on investment to evaluate the company’s

financial performance will optimize the operating profit margin and total assets turnover

in order to have greater return on investment. In 2009, PT X is only use its asset for

2.63 times to generate sales but it can be covered by having higher operating profit

margin ratio that increase the return on investment. Nevertheless, the higher total asset

turnover is not guarantee that the company’s performance will be better. For example is

performance in 2011, the investment is not profitable even though the managers has

used the company’s asset for 7.28 times to generate sales. The company is only earns

profit for 1,023,393,066 or 2.86 % of total asset invested because the cost of goods sold

has greater increase than its sales. Therefore, they must consider other factors affect to

the ratio such as controlling the cost and expenses that relative to the company’s sales in

order to have better performance.

IV.3 Analyze Residual Income

Residual income is a method used by the researcher to evaluate the company’s

financial performance through considering the minimum required return. The

procedures to calculate the residual income are:

a) Calculating the company’s operating income

Operating Income = Sales – COGS – Operating Expenses

2009

Operating Income

= Rp102,585,357,923 – Rp94,069,440,428 – Rp6,540,619,027

= Rp1,975,298,468

2010

Operating Income

= Rp235,280,028,188 - Rp226,806,854,389 - Rp6,688,787,647

54

= Rp1,784,386,153

2011

Operating Income

= Rp260,091,168,572 - Rp253,928,554,806 - Rp5,139,220,699

= Rp1,023,393,067

The operating income is an income generated by the company from its

operation that sell the product to the customers and it is deducted by the cost and

expenses that relative to the sales. The calculation above informs that the

company’s operating income in 2010 decreased by Rp190,912,315

(Rp1,784,386,153 - Rp1,975,298,468) while in 2011 it decreased by

Rp760,993,086 (Rp1,784,386,153 - Rp1,023,393,067). By having higher

operating income in 2009, it indicates that the company has operated its business

well because the manager is effective to control its cost or expenses. Any

changes occurred in operating income will affect to the residual income that will

be earned by the company.

b) Determine target rate of return

Target rate of return is minimum return that will be earned by the

investors for funds that have been invested in a company to support the

company’s development. In this case, PT X estimates its target rate of return

based on management’s consideration which decides to use return on investment

as minimum return. The return on investment achieved by the company

indicates the rate of return that can be offered by the company to its investors.

Thus, at least the company must spend its money at 5.08% of its capital invested

in 2009, 4.21% of capital invested in 2010 and 2.84% of capital invested in

2011. Moreover, the investors will not ask the return below the return on

investment because they will suffer in loss.

55

c) Calculate the minimum required return

Minimum Required Return = Target rate of return X Average Asset

2009

Minimum Required Return = 5.08% X Rp39,071,944,943

= Rp1,984,854,803

2010

Minimum Required Return = 4.21% X Rp42,491,866,505

= Rp1,788,907,580

2011

Minimum Required Return = 2.84% X Rp35,742,262,958

= Rp1,015,080,268

According to those results, the minimum required return in 2010

decreased by Rp195,947,223 (Rp1,788,907,580 - Rp1,984,854,803) while in

2011 it decreased by Rp773,827,312 (Rp1,015,080,268 - Rp1,788,907,580). The

minimum required return reflects to the cost of company’s investment that must

be covered by the company. Thus, the higher required return means the higher

amount of money that must be spent to cover investment’s cost and it may

reduce the residual income. Changes in minimum required return will influence

the company’s residual income. The higher minimum required return will affect

to the lower residual income that will be earned by the company.

d) Calculate the company’s residual income

Residual Income = Operating Income – Minimum Required Return

2009

Residual Income = Rp1,975,298,468 – Rp1,984,854,803

= (Rp9,556,335)

56

2010

Residual Income = Rp1,784,386,153 – Rp1,788,907,580

= (Rp4,521,427)

2011

Residual Income = Rp1,023,393,067 – Rp1,015,080,268

= Rp8,312,799

The results are summarized in the table below:

Table-4.4: Residual Income

Description 2009 2010 2011

Operating Income Rp 1,975,298,468 Rp1,784,386,153 Rp1,023,393,067

Minimum Required Return Rp 1,984,854,803 Rp1,788,907,580 Rp1,015,080,268

Residual Income (Rp 9,556,335 ) (Rp 4,521,427) Rp 8,312,799 Source: Data Processed

The company has good performance if the income earned is higher than

minimum required return on investment. Conversely, it has bad performance if the

income earned is lower than minimum required return on investment. According to the

measurement result, it shows that the residual income in 2011 has positive result

whereas the residual income in 2009 and 2010 has negative result. In 2009 the residual

income of company is (Rp9,556,335) and in 2010 the company’s residual income is

(Rp4,521,427) whereas it is Rp8,312,799 in 2011. The company’s performance in 2009

and 2010 is bad because the company has negative residual income which indicates that

the company is unable to meet the management’s target rate of return. Meanwhile, the

company’s performance in 2011 is good because the company has positive residual

income which indicates that the company is able to meet the management’s target rate

of return and profit earned is able to cover the cost of its investment.

The residual income is influenced by the operating profit and the minimum

required return. The company’s performance in 2011 is good because the minimum

57

required rate of return is lower than operating income and it reflects to the lower return

on investment. It means the company earns the lower profit from each rupiah asset

invested and it would affect to the lower return that will be earned by the investors.

Moreover, the lower minimum required return in 2011 is caused by decreasing in

company’s average assets. It indicates that the capital invested by the company has

decreased also. The average assets are decreasing due to depreciation of fixed assets and

significant decreased in total asset is caused by account receivable where the company

can implement the policy to collect its receivable as well. The company is able to

collect its receivable for 20,208,769,120 and it is around 90% of previous receivable.

Meanwhile, the performance of PT X in 2009 and 2010 are bad because the

income earned is unable to cover the minimum required return or cost of investment.

The higher minimum required return reflects to the higher percentage of profit earned

from each dollar asset invested and the higher total asset invested. The average asset in

2009 is Rp39,071,944,943 and it increases to Rp42,491,866,505 in 2010 due to

increasing in company’s receivable. The increase in the total asset invested is still

unable to increase the profit for the company thus, the company can not meet the

management’s target or to have positive residual income.

Unlike return on investment which measures the company’s performance by the

percentage of profit earned from its assets invested, in this method the decision makers

evaluate the performance by considering the dollar amount of income earned by the

company to evaluate the investment’s effectiveness. By having an income of

Rp8,312,799 in 2011, it means that the performance of PT X is good although in return

on investment calculation its investment decisions is not profitable. It is because the

company receives income from its investments and it may use as additional capital for

the company’s operation in the next period. Meanwhile, the performance of PT X in

2009 and 2010 are bad although in return on investment calculation the investment is

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more profitable. It is because the company gets loss of Rp9,556,335 in 2009 and

Rp4,521,427 in 2010 and it makes the company has no any income from investment

decision that has been made by the manager.

Through using residual income method, the managers promote goal congruence

because they will tend to increase the dollar income that expected by the investors

rather than increase the percentage. Moreover, by having target rate of return at 5.08%

in 2009, 4.21% in 2010 and 2.84% in 2011, the managers have different target rate of

return that must be covered which has been adjusted according to the total capital

invested and profit earned by the company in each year.

IV.4 Analyze Economic Value Added

Economic value added is a method used to evaluate the company’s performance

by considering the cost of capital that must be paid to its investors and long-term

creditors who have spent their money to support the company’s activities. There are five

procedures required to calculating the economic value added:

a) Calculating the NOPAT (Net Operating Profit After Tax)

NOPAT = Net Operating Income X (1 – Tax)

2009

NOPAT = Rp1,975,298,468 X (1 – 30%)

= Rp1,382,708,928

2010

NOPAT = Rp1,784,386,153 X (1 – 30%)

= Rp1,249,070,307

2011

NOPAT = Rp1,023,393,067 X (1 – 25%)

= Rp767,544,800

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In calculating NOPAT, the manager must deduct the operating income

by the tax because it is treated as an expense that must be paid periodically for

every income earned. In this case, the effective tax rate used by the company in

2009 and 2010 are 30% while in 2011 is 25% because there is an alteration in

tax provision. The NOPAT or true operating income earned by the company in

2010 decreased by Rp133,638,621 (Rp1,249,070,307 - Rp1,382,708,928) and

NOPAT in 2011 decreased by Rp481,525,507 (Rp767,544,800 -

Rp1,249,070,307). The lower NOPAT may indicate that the company is not

good enough to operate its business due to decrease in operating income.

b) Calculate Invested Capital

Invested Capital = Average Assets – Current Liabilities

2009

Invested Capital = Rp39,071,944,943 – Rp26,471,111,472

= Rp12,600,833,471

2010

Invested Capital = Rp42,491,866,505 – Rp35,687,596,399

= Rp6,804,270,106

2011

Invested Capital = Rp35,742,262,958 – Rp18,010,248,871

= Rp17,732,014,087

The capital invested by the company consists of net working capital and

non-current asset. The result informs that the invested capital in 2010 decreased

by Rp5,796,563,365 (Rp6,804,270,106 - Rp12,600,833,471) and it is increased

by Rp10,927,743,981 (Rp17,732,014,087 - Rp6,804,270,106) in 2011. Any

changes in invested capital will influence the capital charge and reflects to the

cost of capital. The lower invested capital may reduce the amount of money that

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must be spent by the company to cover the capital charge. However, it also

depends on the weight average cost of capital that will be discussed later.

c) Calculate portion or percentage of debt

The portion of debt reflects to the amount of funds received by the

company from the long-term creditors for making an investment.

wd = 𝒕𝒐𝒕𝒂𝒍 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒚𝒕𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

2009

wd = 𝑅𝑝5,428,528,792 𝑅𝑝13,500,187,702 = 40.21%

2010

wd = 𝑅𝑝970,881,627𝑅𝑝9,324,837,437 = 10.41%

The result informs that in 2009 the company’s long-term liability is

Rp5,428,528,792 or 40.21% of its total capital while in 2010, it decreased to

Rp970,881,627 or 10.41% of its capital. Meanwhile, in 2011 the company has

no long-term liability which indicates that the investment is 100% financed by

its equity. Any changes in total long-term liability will affect to the cost of

capital that must be covered by the company and decreasing the long-term

liability will reduce the financial risk of the company.

d) Calculate after-tax cost of debt

kd*

= kd(1-T) 2009

kd*

= 7.15%(1-30%) = 5.00%

2010

kd*

= 6.50%(1-30%) = 4.55%

In computing after-tax cost of debt, the researcher uses the BI rate to

determine interest rate. BI rate is the “policy rate reflecting to the monetary

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policy adopted by considering the factors in the economy such as inflation”

(www.bi.go.id). After-tax cost of debt indicates the true cost of debt that must be

paid by the company to its creditors for its long-term liability. According to the

calculation, the cost of debt in 2009 that must be covered by the company for

having the loan is 5.00% while in 2010 is only 4.55% because BI rate has

declined from 7.15% to 6.50%.

e) Calculate portion of equity

Equity is the difference between the company’s assets and liabilities or it

can be defined as amount of money that received from the owners, investors,

retained earnings, etc. The portion of equity indicates how much money

received from the owner which has contributed by the company as capital in

investment. It can be determined through this formula:

we = 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒎𝒎𝒐𝒏 𝒆𝒒𝒖𝒊𝒕𝒚𝒕𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

2009

we = 𝑅𝑝8,071,658,910 𝑅𝑝13,500,187,702 = 59.79%

2010

we = 𝑅𝑝8,353,955,810 𝑅𝑝9,324,837,437

= 89.59%

2011

we = 𝑅𝑝8,461,843,208 𝑅𝑝8,461,843,208

= 100%

Based on the calculation above, it informs that in 2009 the company’s

operation is 59.79% financed by its equity and in 2010 it is 89.59% financed by

its equity, meanwhile in 2011 the whole company’s operation or investment is

100% financed by its equity. By increasing the portion of equity in invested

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capital, the manager has reduced the financial risk which is the risk that caused

by having loan where the company must pay the interest rate that can reduce the

company’s income and earning available for shareholders.

f) Calculate cost of Equity

Cost of equity is a cost which reflects to the return that offered by the

company to the investors and long-term creditors for using their money to

support the business’s operation. In this research, the researcher uses the Capital

Assets Pricing Model (CAPM) to compute the cost of equity by considering the

risk free rate and risk premium. The researcher chooses CAPM model to

compute cost of equity because the model is not based on dividend or any

assumption about the growth rate in dividends. It also shows the relationship

between the return and risk which is systematic risk that represented by beta. In

CAPM, there are some components that must be considered to compute the

systematic risk or market risk such as market return that computed based on

Jakarta Composite Index and stock return that computed based on company’s

stock price. Due to PT X is a private company, it has no stock price. Therefore,

the researcher chooses the listed company which has same interest rate as PT X

to compute the CAPM especially for obtaining the market price as important

component to compute beta (ß). In this research, the researcher determines the

interest rate by using BI rate, thus the researcher chooses the listed company

which has same interest rate as BI rate or it is almost same as BI rate.

The basic consideration of the researcher to choose the listed company

which has same interest rate as PT X is the credit risk. In Accounting Tools

(2011), Credit risk is “the risk of loss by a person or entity that has extended

credit to another party, if the other party does not pay the specified amount

within the appointed time period.” According to Adzani (2012), “credit risk is

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influenced by interest rate and thus the higher interest rate means the higher

interest expense that must be paid by the company in every year and the higher

potential risk that the borrowers unable to repay its debt.” Credit risk is also

influenced by the company’s cash flow from operation which reflects to the

company’s financial condition or company’s ability to cover its debt. After all,

credit risk may represent the chance for the investor or they will lose their

investment.

As mentioned above, researcher must collect some data to determine

beta (ß) such as BI rate, JCI (Jakarta Composite Index) and stock price. BI rate

took from Bank Indonesia and it is used by the researcher to determine the risk

free rate (kf). According to the information stated in Bank Indonesia, it shows

that the rate in 2009 is 7.15% and it decreases to 6.50% in 2010, whereas in

2011 it increases to 6.58%.

JCI (Jakarta Composite Index) or IHSG (Indeks Harga Saham

Gabungan) is a combination of several stocks that used to measure the

performance of stocks that listed on the Indonesia Stock Exchange and it shows

the price movement of stocks. JCI has relationship with stocks return especially

for determining the cost of equity. The researcher obtains JCI from BAPEPAM

(Badan Pengawas Pasar Modal) that will be used by the researcher to determine

market return (Km) which computes by using formula below:

km = (JCIt – JCIt-1) ÷ JCIt-1

Beside BI rate and JCI, the important part to compute the cost of equity

by using CAPM model is the stock price which is the cost of purchasing on an

exchange. The price movement of stock can be affected by economic condition

such as inflation, company’s earning, etc. and it influences the stock return that

will be affected to the cost of equity. The higher stock price may indicate the

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higher return that expected by the investors but the higher cost that will be paid

by the company. The stock price took from the Indonesia Stock Exchange (IDX)

that will be used by the researcher to determine the return stock (Ki) which

computed by the equation:

ki = (Pt – Pt-1) ÷ Pt-1

In this case, the company obtaining the stock price by considering the

interest rate as explained before. Thus, in 2009 the researcher uses the stock

price of Lautan Luas Tbk. (LTLS) which has interest rate at 8.75% that is almost

same as BI rate. PT Lautan Luas Tbk. (LTLS) was established in 1951 under the

name Perusahaan Andil Maskapai Dagang dan Industri Lim Teck Lee

(Indonesia). The scope of company’s activities includes trading, manufacturing,

agribusiness and providing services, mining, and service stations. The main

activity of company is involved in the distribution of chemicals and the

acquisition of investment in companies whose business is the manufacture of

chemicals. The products of LTLS are Alkyl Benzene Sulphonic Acid, Dry Sand,

Foaming Agents and Rubber Chemical, and other chemicals. Alkyl Benzene

Sulphonic Acid is used to make soap and detergent, Dry Sand is used to make

glass and ceramic, whereas Foaming Agent and Rubber Chemical are used to

make tire and footwear. (PT Lautan Luas Tbk.)

In 2010, the researcher uses the stock price of AKRA which has interest

rate at 8.35% that is almost same as BI rate. PT AKR Corporindo Tbk. (AKRA)

was established in Surabaya on November 28, 1977. The scope of company’s

activities includes comprises of chemical industry, general trading and

distribution of primarily chemical products and petroleum products and gas. The

company is currently engaged in the distribution of petroleum products to

industrial customers, distribution and trading of chemical products such as

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caustic soda, sodium sulphate that used by various industries in Indonesia in

accordance with distributorship agreements with foreign and local

manufacturers, rental of warehouses, transportation vehicles and other logistics

services. (PT AKR Corporindo Tbk.)

In 2011, the researcher uses the stock price of INTA which has interest

rate at 10% that is almost same as BI rate. PT INTRACO PENTA Tbk. (INTA)

was established on May 10, 1975 in Jakarta. The scope of company’s activities

is to engage mainly in trading and leasing of heavy equipment and spare parts

and to provide services related to assembling and repairs. The products of INTA

are VOLVO construction equipment (Excavator, Articulated Hauler, Motor

Graded, and Compactor), INGERSOLL-RAND (Compressor, GenSet, and Light

Source), Bobcat (Skid Steer Loader, Mini Excavator, and Telescopic Handler)

and other heavy equipments. VOLVO is a machine developed to perform

haulage duties and construction, INGERSOLL-RAND is developed for lighting

purpose whereas Bobcat is a machine that developed for digging and moving

heavy items. (PT INTRACO PENTA Tbk.)

By having BI rate, JCI, and stock price, the researcher can compute the

beta (ß) to determine the cost of equity by using formula below:

ß = 𝑪𝒐𝒗 (𝑲𝒊,𝑲𝒎)𝑽𝒂𝒓 (𝑲𝒎)

According to the calculation in table-4.5, it shows that in 2009 the beta

or systematic risk is 0.22834 or 22.834% which indicates that the stock's price

movements of LTLS are smaller than stock’s price in JCI. It means the stock

return is 22.834% less than its return market. Moreover, the lower beta indicates

the lower risk and lower return that will be earned by the investors.

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In 2010 the beta is 1.32115 or 132.115% which indicates that the stock's

price movements of AKRA are greater than the stock market. It means the stock

return is 132.115% greater than its return market. Moreover, the higher beta

indicates the greater risk for the investors and it reasonable for them to expect

greater return that will be earned by the investors.

Meanwhile, in 2011 the systematic risk (beta) is 0.86571 or 86.571%

which indicates that the stock return is 86.571% lower than its return market.

The lower beta means the lower risk for the investors and they will earn the

lower return.

Table-4.5: Systematic Risk (Beta) 2009-2011

Month 2009 2010 2011

Km Ki Km Ki Km Ki

January -0,01678 -0,01887 0,03016 0,00855 -0,07948 0,09184 February -0,03541 0,17308 -0,02366 -0,13559 0,01795 0,01869 March 0,11559 0,40984 0,08955 -0,08824 0,06003 0,31193 April 0,20132 -0,09302 0,06983 0,10753 0,03832 0,01399 May 0,11264 0,05128 -0,05866 -0,05825 0,00454 0,06897 June 0,05736 -0,07317 0,04173 0,09278 0,01345 -0,80645 July 0,14627 0,07895 0,05340 0,12264 0,06229 0,12000 August 0,00788 0,00000 0,00411 0,03361 -0,06998 -0,09524 September 0,05383 0,00000 0,13609 0,22764 -0,07619 -0,11842 October -0,04048 -0,04878 0,03828 0,00000 0,06814 0,00000 November 0,02033 -0,11538 -0,02864 -0,03311 -0,01999 -0,08955 December 0,04906 0,08696 0,04879 0,18493 0,02878 -0,03279 Total 0,67161 0,45087 0,40099 0,46249 0,04785 -0,51704 Beta 0,22834 1,32115 0,86571

Source: Data Processed

After determining stock beta, then the researcher calculate cost of equity

and its calculation is shown below:

ke = krf + (km – krf)ß

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2009

ke = 7.15% + (5.60% - 7.15%) 22.83%

= 7.15% + (-1.55%) 22.83% = 6.80%

2010

ke = 6.50% + (3.34% - 6.50%) 132.11%

= 6.50% + (-3.16%) 132.11% = 2.33%

2011

ke = 6.58% + (0.4% - 6.58%) 86.57%

= 6.58% + (-6.18%) 86.57% = 1.23%

Based on the calculation, it shows that the cost of equity in 2010 that

must be covered by the company due to receiving funds from the investors has

decreased by 4.47% (2.33% - 6.80%) and in 2011 it decreased by 1.10% (1.23%

- 2.33%). The lower cost of equity indicates the lower return of money that

being invested and the lower level of risk faced by the investors. The lower cost

of equity is caused by the decreasing in BI rate and market return, thus it affects

to the lower stock return. Any changes in cost of equity will affect to the cost of

capital which must be covered by the company in each year.

g) Calculate WACC

WACC = wdkd(1-T) + weke

2009

WACC = (40.21% X 5%) + (59.79% X 6.80%)

= 2.01% + 4.07% = 6.08%

2010

WACC = (10.41% X 4.55%) + (89.59% X 2.33%)

= 0.47% + 2.09% = 2.56%

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2011

WACC = 100% X 1.23% = 1.23%

According to the formula above, it shows that in 2009 the company must

spend 2.01% of its capital for its creditor and 4.07% for its investors. In 2010,

the company must spend for 0.47% of its invested capital to its creditor and

2.09% for its investors. Meanwhile, in 2011 the company is only spending

1.23% of its invested capital to its investors because the company has repaid its

long-term liability. The cost of capital indicates the amount of money that must

be spent by the company to its creditor or investors and the lower cost of capital

will affect to the higher economic value added.

h) Determine Capital Charge

Capital Charge = Invested Capital x WACC

2009

Capital Charge = Rp12,600,833,471 X 6.08% = Rp776,130,675

2010

Capital Charge = Rp6,804,270,106 X 2.56% = Rp174,189,315

2011

Capital Charge = Rp17,732,014,087 X 1.23% = Rp218,103,773

The researcher calculates the capital charge based on the formula above

and the result shows that the highest cost is Rp776,130,675 and it must be

covered by the company in 2009 as cost of investment. Meanwhile, the lowest

cost is Rp174,189,315 that must be covered in 2010. Indirectly, the cost of

investment reflects to the return of money that being invested by creditors and

investors. The lower capital charge will affect to the positive economic value

added. However, it also depends on the company’s NOPAT or true operating

income earned by the company.

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i) Determine EVA

EVA = NOPAT - Capital Charge

2009

EVA = Rp1,382,708,928 - Rp776,130,675 = Rp616,578,253

2010

EVA = Rp1,249,070,307 - Rp174,189,315 = Rp1,074,880,992

2011

EVA = Rp767,544,800 - Rp218,103,773 = Rp549,441,027

The results are summarized in the table below:

Table-4.6: Economic Value Added

Description 2009 2010 2011

NOPAT Rp1,382,708,928 Rp 1,249,070,307 Rp 767,544,800

Capital Charge Rp 776,130,675 Rp 174,189,315 Rp 218,103,773

EVA Rp 616,578,253 Rp1,074,880,992 Rp 549,441,027 Source: Data Processed

The company has good performance if the income earned from its operation is

higher than cost of capital. Conversely, it has bad performance if the income earned

from its operation is lower than its cost of capital. According to the calculation that has

been conducted by the researcher, the company’s economic value added during three

years period shows the positive result. In 2010, the economic value added increased by

Rp458,302,739 (Rp1,074,880,992 - Rp616,578,253) while in 2011, it decreased by

Rp525,439,966 (Rp549,441,027 - Rp1,074,880,992). The positive economic value

added indicates that the company has performed its business well because the company

is able to create the economic value from its invested capital even though the true

operating income has decreased in 2011. Moreover, it meets the expectation of investors

and creditor because PT X is able to cover its cost of capital and has additional funds to

70

support company’s operation. In other words, the performance of company during three

years period is good.

Economic value added is influenced by several factors and positive economic

value added is influenced by increasing the company’s NOPAT and decreasing the

company’s cost of capital. In 2009, the EVA shows the positive result that caused by

good operation where the manager can manage or control the cost and expense relative

to the sales, thus it has true operating income for Rp1,382,708,928. Moreover, the

economic value that created by the company is caused by the cost of capital that lower

than its operating income. The lower cost of capital is influenced by cost of debt and

cost of equity that must be paid by the company in every year to meet its obligation to

its creditor and investors. In 2009, the cost of debt that must be paid by the company is

2.01% because the company has long-term liability for Rp5,428,528,792 or 40.21% of

its total capital to finance its operation. Meanwhile, cost of equity that must be paid to

its investors is 6.08% because 59.79% of total capital invested is financed by its equity.

In 2010, the positive EVA is influenced by increasing in net operating income

and decreasing in cost of capital. The net operating income after tax decreased by

Rp133,638,621 (Rp1,249,070,307 - Rp1,382,708,928) from previous year and it caused

by increasing in cost of goods sold and operating expense. The higher cost and expense

offer an indication that the managers have not done their tasks or responsibilities as well

to manage the cost that relative to the sales. Meanwhile, the decreasing cost of capital is

influenced by several factors such as decreasing in BI rate, market return and increase

stock price. In 2010, company’s cost of debt decreased by 0.45% (5.00% - 4.55%) and

it indicates that the company has repaid some of its long-term liability in 2009.

Moreover, it caused by the decreasing in BI rate from 7.15% to 6.5% which indicates

that government is able to control inflation and “it has decrease at a rate of 5.3 percent.”

(VIVAnews: Monday, December 9, 2010).

71

Decreasing in BI rate offers another indication that the government tries to

improve the economic growth of Indonesia. “The lower BI rate has positive impact

because it would increase the economic activities. The lower BI rate will reduce the

lending rate that would encourage the people or investors to increase credit application

for investment purpose and support the company’s operation. Then, they can run the

economic activities as well because they obtain sufficient amount to operate and

develop the business. Thus, it increases the economic growth level from 4.5% in 2009

to 6.1% in 2010”. (Suara Pembaruan: Monday, February 7, 2011). The decrease in BI

rate also affect to the lower cost of equity that must be paid by the company to its

investors. Besides BI rate, the other factors that reduce the cost of equity are market

return and stock return. The lower market return and higher stock return would affect to

the higher systematic risk which indicates that the investors have greater risk for

investing their money and it would encourage the higher return that expected by the

investors. Moreover, the higher stock return is indirectly indicates that the company’s

stock price is increased also and it reflects to the higher of company’s EPS.

In 2011, the economic value added calculation shows the positive result due to

decreasing in net operating income and cost of capital. The decrease in company’s net

operating income is caused by increasing cost of goods sold. The cost of goods sold in

2011 has greater increase rather than its sales which indicates that the manager is not

effective to control its cost. Meanwhile, the cost of capital is decreased due to the

company has paid its all obligation to the creditors thus PT X has no long-term liability

anymore. Through decreasing in long-term liability indicates that the company has

reduced its financial risk which is paying the interest rate as cost of debt that will reduce

the company’s income. However, it would increase the business risk which is the risk

that may face by the company in operating its business for example the competition in

business world. Moreover, the factors that reduce the cost of capital are the lower

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market return and stock return that will affect to the return that will be received by the

investors.

Positive economic value added in 2011 is also influenced by the total invested

capital which shows that it increases from Rp6,804,270,106 to Rp17,732,014,087. It

caused the current liabilities has greater decrease rather than its average assets. The

average asset in 2011 decreases because the company’s receivable has declined. It

indicates that the company has implemented its collecting policy as well thus its

receivable can be collected faster. Its receivable has decreased by Rp20,208,769,120

whereas its current liabilities decreased by Rp17,677,347,530. The lower receivable and

lower current liabilities may offer an indication that the company has utilized its

receivable to cover its current liabilities. Thus, the performance of PT X in 2011 still

good even though its income has decreased because the company has reduced the

invested capital and cover its long-term liability.

In practice, EVA evaluates the performance of company by considering cost of

capital that must be paid to meet expectation of its creditor and investors as funds

providers to support company’s operation. By computing weight-average cost of

capital, the company can estimate how much money that must be spent in every year to

cover cost of debt and cost of equity. Based on the calculation, the company has

economic value for Rp616,578,253 in 2009, Rp1,074,880,992 in 2010 and

Rp549,441,027 in 2011. By having an income, it indicates that the investment decision

that has been made by manager is effective. Then, those incomes will affect the

manager’s decision whether to allocate its income for supporting the company’s

operation in the next period or to make a new investment such as buying car or other

equipment that may support the company’s activities.

Unlike residual income which evaluates the performance of PT X by using

return on investment as minimum return, Economic Value Added evaluates the

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performance of PT X by considering the weight average cost of capital to determine the

minimum return. Thus, the performance of PT X in 2009 and 2010 that evaluated by

residual income is bad because the company gets loss for Rp9,556,335 in 2009 and

Rp4,521,427 in 2010 thus it does not meet the management’s consideration or target

rate of return. The return on investment, as target rate of return, is only consider the

investor’s expectation which offer the return for using their funds however, the funds

provider is not only derives from the investors but it also derives from the creditors

because the company has long-term liability to support its operation. Moreover, target

rate of return is about estimation and it is difficult to determine what number that will

be used to estimate the rate of return. Moreover, by considering the expectation of

creditors which is interest expense, the manager has considered the risk that will reduce

the company’s income. Thus, they are encouraged to meet the expectation of its creditor

and it would affect to the creditor’s credibility toward company, then it enables the

company to have loan in the future.

Conceptually, the economic value added and residual income are same because

those methods evaluate the performance of company by considering the income earned

that must be higher than minimum required return. Residual income defined the cost of

investment as management’s target return whereas EVA defined it as cost of capital that

must be covered by the company to meet investor’s expectation. Same as Residual

income, EVA is also encouraging the manager to promote goal congruence because

EVA has aim to increase the dollar amount of income rather than increase the

percentage of income. Moreover, by considering the cost of capital the manager may

optimize the capital structure to develop its business and having much income.

Nevertheless, the managers are still hard to determine or get proper company’s cost of

equity because the company must calculate beta that measures market risk for investors

who invest their money by considering the market return, stock return and interest rate.

74

Meanwhile, the positive result in economic value added calculation is only an indication

of economic value of the company in certain period and it does not indicate the entire

company’s economic value.

IV.5 Comparison of Method and Its Benefit for Decision Making In Investment

In practice, the combination of these three methods would complement each

other to evaluate the financial performance of the company. In the previous discussion,

it explains that those methods are used to evaluate the company’s financial performance

through considering company’s profit and return of money that being invested. The

methods have different concept in calculation and it offers its own benefit that can be

used as consideration to make project or investment. From return on investment, the

manager will know the potential profit that will be earned by the company from its

investment and manager’s effectiveness in managing its assets to make profit. Then,

from residual income the manager will know the dollar income that will be earned by

the company from its investment through different target rate of return. Meanwhile,

from economic value added the manager will know how much money that will be spent

by the company to cover its cost of capital and it measures the economic value that

created by the company from its investment.

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CHAPTER V

CONCLUSION AND RECOMMENDATION

V.1 Conclusion

The performance evaluation is necessary for the company to discover the

financial condition of company and the researcher has evaluated the financial

performance of PT X in 2009, 2010 and 2011 by using return on investment, residual

income and economic value added. According to the measurement result, the researcher

provides some conclusions relative to the company’s achievement in running its

business and these conclusions are reflected to the problem identification and statement

of this thesis. Thus the conclusions are:

V.1.1 How do we measure the company’s financial performance using Return on

Investment (ROI), Residual Income (RI) and Economic Value Added

(EVA)?

Each method has different result in evaluating the financial performance of PT

X and the results are summarized below:

1) Return on investment

The company’s return on investment in 2009 is 5.08% which means the

company is able to generate profit for Rp0.0508 from each rupiah asset invested.

In 2010 the return on investment is 4.21% which means the company is able to

generate profit for Rp0.0421 from each rupiah asset invested. Whereas in 2011,

the ratio is 2.84% which indicate that the company is able to generate profit for

Rp0.0284 from each rupiah asset invested. Thus, it concludes that by using

return on investment the performance of PT X in 2009 is better than

performance in 2010 and 2011 because the investment has higher potential

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profit while performance of PT X in 2011 is worse than performance in 2009

and 2010 because the investment has lower potential profit.

2) Residual Income

According to the calculation, the residual income in 2011 has positive

result which is Rp8,312,799 in 2011. Meanwhile, in 2009 and 2010 the residual

income shows the negative result which is (Rp9,556,335) in 2009 and

(Rp4,521,427) in 2010. Thus, it concludes that the company’s performance in

2011 is good because the company has positive residual income which indicates

that the company is able to meet the management’s target rate of return.

Meanwhile, the company’s performance in 2009 and 2010 are bad because the

company has negative residual income which indicates that the company does

not meet the management’s target rate of return and profit earned is unable to

cover the cost of its investment.

3) Economic Value Added

According to the economic value added calculation that has been

conducted by the researcher, it shows that the company has positive economic

value added during three years period. The economic value added is

Rp616,578,253 in 2009, it is Rp1,074,880,992 in 2010 and Rp549,441,027 in

2011. The positive economic value added indicates that the company has

performed its business well. It is because the company is able to create the

economic value from its invested capital even though the true operating income

has decreased in 2011. Moreover, the positive economic value added indicates

that the company meets the expectation of investors and creditor because PT X

is able to cover its cost of capital. In other words, the performance of company

during three years period is good.

77

V.1.2 With those methods, which method provides more useful information for

the managers to evaluate the company’s financial performance?

For the short-run decision, the method that provides more useful

information for managers to evaluate the company’s financial performance is

return on investment. It is because the return on investment evaluates the

performance by considering the operating profit earned and total assets that

being invested. The managers will tend to accept the profitable investment that

will increase the performance of managers. Thus, it will encourage the managers

to increase the return on investment by managing the operating profit margin

and total assets turnover of company.

The concept of return on investment method is easy to be understood and

the managers who use that method will tend to increase the percentage of return

on investment in order to increase their performance. However, in practice the

managers may not understand enough how to increase the return on investment.

They may take actions to increase the return on investment in the short run but it

has bad impact for the company in the long run such as suffer a financial loss.

Therefore, the managers should use another method that considers investment

decision or company’s performance in the future and economic value added

method covers the return on investment criticism.

In practice, EVA evaluates the company’s financial performance by

considering the dollar amount of income rather than percentage of income that

will be earned by the company. The managers who use EVA will tend to

increase the dollar amount of income to improve the performance of company

by considering the capital structure and its cost of capital that must be covered

by the company in every year. EVA considers the risk that may be faced by the

company in running its business which is financial risk that will reduce the

78

company’s income in the future. Thus, the managers will tend to reduce the

capital invested to reduce the cost of capital that will reduce the financial risk

and increase the economic profit for the company. Moreover, EVA encourages

the managers to be more innovative to develop the business that can increase the

performance of the company.

V.2 Recommendation

V.2.1 Based on the conclusion above, the researcher has several

recommendations for the company to evaluate its financial performance

that stated as follows:

PT X should evaluate the company’s financial performance in dollar amount

rather than the percentage. It is because the return on investment is only

provides an overview of potential profit that will be earned by the company in

certain period.

The managers must consider the financial performance of company in the long-

run rather short-run performance to support the decision making and develop

the company’s business.

The managers should consider the other things beside income earned from its

operation that affect to the financial performance of company or investment’s

effectiveness. It is like company’s cost of investment that must be paid by the

company because it will reduce the company’s income.

In supporting the evaluation toward company’s financial performance, the

researcher recommends economic value added method to be implemented by

the manager rather than return on investment and residual income. It is because

the residual income determines the company’s cost of investment based on

management’s consideration which is return on investment. Whereas, the return

79

on investment is only consider the potential profit that will be earned. It is

different from economic value added which determines the company’s cost of

investment by considering cost of debt (interest rate) and cost of equity (return

offered to its investors for having investment) that must be paid by the company

for using their funds. The positive economic value added indicates that the

company has economic value that supports the company’s operation.

V.2.2 Based on the conclusion above, the researcher has several

recommendations for the company to optimize the company’s financial

performance that stated as follows:

For the short-run performance, the company should:

a) Increase the company’s sales that would affect to the higher company’s

operating profit. The company can increase its sales through keep

promotes its product to the customers and tries to promote the products

to the other company. Moreover, the company can increase its sales by

changing its marketing strategy for example giving discount for the

customer who buys the product in big size or amount.

b) Reduce the cost or expense that relative to the sales, for example

reducing the account receivable to reduce uncollectible accounts. The

company can consider the credit terms and customer’s ability in

payment to reduce the uncollectible account. Moreover the manager

may reduce inventories to reduce the inventory holding cost. The

company can use Just-In-Time system which is a system that focuses to

eliminate the number of inventory in which the company will purchase

the inventory according to customers need and it will reduce the holding

cost.

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For long-run performance, the company should:

a) Change the capital structure of company to reduce the cost of capital.

The company may reduce cost of capital by reducing the portion of debt

toward total capital that will be used to make an investment. Then, it

would reduce the financial risk for the company which is reducing the

risk for paying the interest.

b) Increase the company’s sales by improving the performance of

marketing division. For example, keep in touch with the customers or

build good relationship with them.

c) Invest in company's asset that can increase profits and improve

company’s financial performance, for example is buying the vehicle for

supporting company’s operation to deliver the products. If the company

can deliver the product on time, then it will create the customers

satisfaction and they will decide to purchase the products again. It means

the company’s sales will increase and it can generate more profit for

company.

81

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APPENDICES

I. Statement of Financial Position of PT X during three years period (2009-2011)

Description As of December

31, 2009

As of December

31, 2010

As of December

31, 2011

Asset:

Current Asset

Cash and Cash Equivalents 4,235,159,689 5,254,327,229 1,282,689,065

Account Receivable 20,854,211,480 22,445,934,312 2,237,165,192

Inventories 9,912,965,832 12,520,244,357 13,599,942,034

Prepaid Taxes - 103,808,960 168,720,591

Other Receivables - 467,517,250 -

Total Current Assets 35,002,337,001 40,791,832,108 17,288,516,882

Non-Current Asset

Property, Plant and Equipment

Net of Accumulated

Depreciation respectively

amounting to 4,549,737,015;

4,405,037,566; 5,040,982,960

4,968,962,173 4,220,601,728 3,233,660,553

Other Assets - - 5,949,914,644

Total Non Current Assets 4,968,962,173 4,220,601,728 9,183,575,198

Total Asset 39,971,299,174 45,012,433,836 26,472,092,079

Liability:

Current Liabilities

Account Payable 17,700,553,089 21,601,411,844 11,334,320,448

Unearned Revenue 8,770,558,383 - -

Bank Payable - 13,507,579,039 6,282,856,892

Leasing Payable - 47,816,667 -

Taxes Payable - 530,788,848 393,071,530

Total Current Liabilities 26,471,111,472 35,687,596,399 18,010,248,871

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Non Current Liabilities

Bank Payable 5,428,528,792 970,881,627 -

Total Non Current Liabilities 5,428,528,792 970,881,627 -

Total Liabilities 31,899,640,264 36,658,478,026 18,010,248,871

Equity:

Share Capital - Issued and

fully paid 8,000 shares with

par value of Rp930,000

7,340,000,000 7,440,000,000 7,440,000,000

Retained Earnings 327,759,573 568,538,092 913,955,810

Net Income 403,899,337 345,417,718 107,887,398

Total Equity 8,071,658,910 8,353,955,810 8,461,843,208

Total Liability and Equity 39,971,299,174 45,012,433,836 26,472,092,079 Source: Financial Reporting of PT X

II. Statement of Comprehensive Income of PT X from January 1st to December 31st

during three years period (2009-2011)

Description 2009 2010 2011

Net Sales 102,585,357,923 235,280,028,188 260,091,168,572

Cost of Goods Sold (94,069,440,428) (226,806,854,389) (253,928,554,806)

Gross Profit 8,515,917,495 8,473,173,799 6,162,613,766

Operating Expenses:

Selling and Administrative expense (6,540,619,027) (6,688,787,647) (5,139,220,699)

Total Operating Expense (6,540,619,027) (6,688,787,647) (5,139,220,699)

Operating Profit (Loss) 1,975,298,468 1,784,386,153 1,023,393,067

Other Income (Expenses) (1,571,399,132) (799,816,902) (879,543,202)

Profit (Loss) Before Tax 403,899,336 984,569,251 143,849,864

Income Tax (163,120,720) (639,151,532) (35,962,466)

Net Profit (Loss) 240,778,616 345,417,719 107,887,398 Source: Financial Reporting of PT X

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III. BI Rate for three years period (2009-2011)

Description 2009 2010 2011 January 8.75% 6.50% 6.50% February 8.25% 6.50% 6.75% March 7.75% 6.50% 6.75% April 7.50% 6.50% 6.75% Mei 7.25% 6.50% 6.75% June 7.00% 6.50% 6.75% July 6.75% 6.50% 6.75% Augustus 6.50% 6.50% 6.75% September 6.50% 6.50% 6.75% October 6.50% 6.50% 6.50% November 6.50% 6.50% 6.00% December 6.50% 6.50% 6.00% Total 85.75% 78.00% 79.00% Average 7.15% 6.50% 6.58%

Source: Bank Indonesia

IV. Jakarta Composite Index for three years period (2009-2011)

Description

2009 2010 2011

JCI km JCI km JCI km

Previous Month 1355.41 2534.36 3703.51 January 1332.67 -0,01678 2610.80 0,03016 3409.17 -0,07948 February 1285.48 -0,03541 2549.03 -0,02366 3470.35 0,01795 March 1434.07 0,11559 2777.30 0,08955 3678.67 0,06003 April 1722.77 0,20132 2971.25 0,06983 3819.62 0,03832 Mei 1916.83 0,11264 2796.96 -0,05866 3836.97 0,00454 June 2026.78 0,05736 2913.68 0,04173 3888.57 0,01345 July 2323.24 0,14627 3069.28 0,05340 4130.80 0,06229 Augustus 2341.54 0,00788 3081.88 0,00411 3841.73 -0,06998 September 2467.59 0,05383 3501.30 0,13609 3549.03 -0,07619 October 2367.70 -0,04048 3635.32 0,03828 3790.85 0,06814 November 2415.84 0,02033 3531.21 -0,02864 3715.08 -0,01999 December 2534.36 0,04906 3703.51 0,04879 3821.99 0,02878 Total 24168.88 0,67161 37141.52 0,40099 44952.83 0,04785 Average 2014,07 0,05597 3095,13 0,03342 3746,07 0,00399 Source: Bapepam (Data Processed)

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V. Market Stock Price for three years period (2009-2011)

Description

2009 (LTLS)

2010 (AKRA)

2011 (INTA)

IHSI ki IHSI ki IHSI ki

Previous Month 530 1170 2450 January 520 -0,01887 1180 0,00855 2675 0,09184 February 610 0,17308 1020 -0,13559 2725 0,01869 March 860 0,40984 930 -0,08824 3575 0,31193 April 780 -0,09302 1030 0,10753 3625 0,01399 Mei 820 0,05128 970 -0,05825 3875 0,06897 June 760 -0,07317 1060 0,09278 750 -0,80645 July 820 0,07895 1190 0,12264 840 0,12000 Augustus 820 0 1230 0,03361 760 -0,09524 September 820 0 1510 0,22764 670 -0,11842 October 780 -0,04878 1510 0 670 0 November 690 -0,11538 1460 -0,03311 610 -0,08955 December 750 0,08696 1730 0,18493 590 -0,03279 Total 9030 0,45087 14820 0,46249 21365 -0,51704 Average 752,5 0,03757 1190 0,03854 1780,42 -0,04309

Source: Indonesia Stock Exchange (Data Processed)