Effective Use of Capital
by MAURICE S. NEWMAN Partner, Executive Office
Presented before the Northwestern University Management Conference, Chicago—November 1963
THE EFFECTIVE USE of capital within a company is vitally important to its success. There will, of course, be differences of opinion voiced within a company about who can more effectively use the available capital, but it should be possible for people with various functional backgrounds such as sales, production, and accounting to reconcile their parochial viewpoints and to aim jointly for a common
goal. It is important to recognize the cost of capital and to use it where it will produce the best return on the investment.
The use of the return-on-investment concept as an objective test of planning and as a measurement of performance has been given a substantial boost by the post-war trend toward diversification through merger and acquisition and the concurrent trend toward the centralization of profit responsibility. One of the reasons for its widespread application is that it translates financial objectives into more familiar terms, such as selling prices, profit margins, sales turnover, operating costs, and capital equipment which are more easily understood by sales and production personnel.
Where two businesses are operating independently, the earning statements of each will give a reasonable indication of the return on investment. When these entities become merged, however, and various administrative functions are shared jointly, it becomes more difficult to determine the contribution of each to the over-all profits of the company. The same is true when there are various divisions within a company or when various product groups are competing for the available capital resources.
The beauty of the return-on-investment concept lies in its pure simplicity of logical accounting analysis. It clearly relates the earnings
per share to the manifold operations of the business. Step by step, it shows how the net return on equity can be affected not only by the amount of net profit but also by the amount of equity. It goes on to show that net profit can be influenced not only by the profit margin but also by the sales turnover. It also points up the leverage