Return on Invested Capital: Cash's Role
Return on invested capital means different things to different people, because capital is a somewhat amorphous term and the modifier "invested" further complicates things. The main issue we'll look at in this last section of the ROIC series is the amount of cash that a company carries and how that plays into the calculation of ROIC.
Earlier, we explained that the denominator in ROIC -- invested capital -- can be calculated primarily from the liabilities & equities side of the balance sheet or primarily from the asset side of the balance sheet. This stands to reason because the accounting tautology of assets minus liabilities equals owners' equity (A - L = OE) can be restated as assets equals liabilities plus owners' equity (A = L + OE). The capital that can be invested by management can be looked at through either prism (subject to some distortion-corrections in either case), but the amounts of invested capital must agree with one another. At the very least, they must be in the same neighborhood.
Let's review the definition of invested capital and ROIC. The invested capital base is total assets minus noninterest-bearing current liabilities, and the return is after-tax operating earnings. This is the more hardball way of defining the capital base, though. In Graham and Dodd's Security Analysis, return on capital is defined differently. The definition of return on capital in the fifth edition of that venerable tome is net income plus minority interest plus tax-adjusted interest (basically, after-tax operating profit) all divided by assets minus intangible assets (like goodwill or patents) minus short-term accrued payables. We accounted for the intangibles by looking at the difference between financial capital and capital that operating managers can actually lay their hands on, but we don't depart from Graham and Dodd on cash invested in the business. Whether it's funded by liabilities or owners' equity, the cash represents capital that has been invested in the business. However, there is a difference between invested and deployed, which is where some investors and analysts differ in their view of ROIC.
In our original definition of return on invested capital, we defined ROIC as after-tax operating profit divided by total assets minus noninterest-bearing current liabilities minus cash. Some feel more comfortable with this definition because cash represents capital that hasn't been deployed in other assets or represents potential to reduce liabilities or owners' equity. It's useful to see how well companies are using the assets they've actually deployed in their businesses.
However, if a company is having trouble finding outlets to invest excess cash, the most conservative way to look at the company's ROIC performance may be to look at ROIC using a capital base that doesn't deduct the idle cash. If one were to judge the company on the huge ROIC with a capital base that didn't include the cash, one might falsely conclude that it is severely undervalued -- when in reality, it couldn't hope to invest all its cash in high-yielding business projects.
In the case of a fast-growing company that has issued securities but has not yet deployed the cash from those issuances, we don't want to get too racy with what we consider excess capital. On one hand, you wouldn't expect an acquirer simply to take that cash out of the business. But we also don't want to unduly penalize the company's valuation just because we are taking a snapshot of the financials at a time when it has not yet had the chance to invest all the capital that it has at its disposal. A compromise is in order.
Depending on the capital intensity and the speed at which a company can turn inventory into cash (its cash conversion cycle), the invested capital base of the company should reflect only the cash balance that a company needs to have on hand to cover day-to-day cash outlay needs. For instance, most restaurants that aren't going under need to retain very little cash on hand because they operate in a cash business. Their inventory is turned into cash very quickly, while the payables for the inventory operate on a cycle not all that different from any other business with a good credit rating. Large industrial companies, on the other hand, take much longer to turn a pile of sheet steel or aluminum and a bunch of electronics into a final sale. They need a good deal of cash on hand to cover necessary cash disbursements in the normal course of a business cycle.
The compromise ROIC is thus: after-tax operating profit divided by assets minus noninterest-bearing current liabilities minus excess cash. Excess cash is cash beyond 0% to 20% of revenues. This level is left to the discretion of the investor, but conservatism is the better part of valor here. When some analysts look at a company and say, "Look at all that excess cash," it's not as if you could go in and buy out the company and pay down the debt you issued to acquire it. And it's not as if the company's profitability should be measured on an invested capital base from which all cash has been deducted.
Most companies need a bunch of cash for several reasons. They need to be able to weather business downturns. In addition, many businesses take awhile to convert cash into inventory into revenue and back into cash again. For them, a higher percentage of base cash is appropriate.
On the other hand, companies that turn cash into inventory into revenue back into cash very quickly need less cash to operate. In that case, any cash that it carries beyond a very small percentage of revenue should be deducted from its capital base.
As a compromise, this can work better and be more flexible than the very hardcore definition of invested capital we originally stated. Some businesses carry a bunch of cash, but an investor shouldn't deduct all cash from its capital base. Just because the company has a good ROIC and good margins doesn't mean that its cash conversion cycle and capital investment needs release it from holding cash on the balance sheet. If it chose to shoot all its cash back to shareholders, whatever short-term debt it would need to finance its working capital would show up in its invested capital base.
For more lessons on return on invested capital, follow the links at the bottom of our introductory article.