Return on Invested Capital: Better Than Return on Equity
As we said in the first part of this series, return on invested capital is like return on equity (ROE) -- but even better.
True, balance sheets using GAAP (Generally Accepted Accounting Principles) can understate the amount of resources that a company currently has at its disposal. In turn, that can overstate the company's return on capital, luring investors into misjudging a business's performance and economics.
However, return on invested capital still leaves ROE in the dust for a number of reasons. First, ROE uses only the residual of assets minus liabilities as the invested capital base. A 15% return on equity might seem acceptable in all circumstances, but without also knowing how much leverage the company's taken on, and its return on all capital, investors can't truly know whether a potential investment is safe.
Here's a theoretical balance sheet:
- Total assets: $3,000
- Accounts payable: $200
- Accrued compensation expenses: $200
- Current portion of long-term debt: $100
- Long-term debt: $1,750
- Total liabilities: $2,250
- Shareholders' equity: $750
With these numbers, a company generating earnings of $112.50 during the fiscal year would run a nominally great return on equity of 15%. But the picture looks far less rosy when you compare earnings to all the capital invested in the business, long-term or short-term -- in other words, owners' equity and all financial debt.
There are two ways to add up the capital at work, according to the theoretical work of Bennett Stewart III in The Quest for Value: The EVA Management Guide. (His theories are backed up by a heck of a lot of practical application by Stewart and his partners at his investment firm, so this isn't just propellerhead stuff). You can add up the capital a firm is using by focusing primarily on the right-hand side of the balance sheet, where you find liabilities and owners' equity, or by looking primarily on the left-hand side of the balance sheet, which lists assets. Remember, assets minus liabilities equals owners' equity -- the bottom line on a balance sheet.
Let's flip it around
Rearranging the equation, though, gets us to an expression of how all assets are funded on a balance sheet: assets = liabilities + owners' equity.
In short, we can define invested capital as equal to all financial capital. To get this number, we'll start with all assets, then deduct non-interest-bearing current liabilities. In the above case, we have total assets of $3,000, from which we subtract non-interest bearing current liabilities of $400 -- the combined sum of accounts payable and accrued compensation expenses.
While they're technically considered debt, these categories don't represent capital invested in the business by either equity or debt holders. As long as a company pays its vendors within standard or agreed-upon terms, accounts payable are not interest-bearing liabilities.
As for accrued compensation expenses, any company that doesn't pay by the day will operate with an average level of these liabilities all year long. If the company is a traditional manufacturer, its inventory represents the value of work that each employee contributes. But while the company's getting this value every day, it's usually only paying workers for it once every two weeks. Between paydays, the value of employees' work adds up; think of it as an interest-free short-term loan of labor.
Either way we look at it, we have $2,600 in invested capital. Now we have to adjust the return before we divide it into invested capital to calculate ROIC. However, the net income figure we used in the calculation of return on equity isn't exactly equal to the "return" in ROIC.
See, ROE is concerned with the return on equity after all other financing sources have been taken care of. Net income is net of interest expense, as well as other expenses below the operating-income line on the income statement. We want to measure the income the company generates before considering what capital costs. This lets us look at the pure earnings power of a corporation, before we factor in the decisions it made to finance the business. Don't worry -- we're not ignoring leverage here. We'll consider the cost of capital later in this series.
For more lessons on return on invested capital, follow the links at the bottom of our introductory article.