Return on Invested Capital: True Performance

Up until now, we've looked at setting up the balance sheet to assess return on invested capital. We now look at the return part of the equation.

As we pointed out in the last article, we want to measure the income the company generates before considering how much its capital costs. In this way, we are looking at the pure earnings power of a corporation before taking into account the decisions that were made to finance the business. Here's the hypothetical income statement we're working with:

Compared to the adjustments that need to be made to the balance sheet, this is the easy part. The return that the company is generating from operations is fully taxed operating income. To calculate, we tax the company's operating income at a standard statutory rate. In the U.S., the standard is around 35%, and it'll be a few points lower for companies with international operations. So the return from operations for the above company is equal to:

Operating income - income tax

or

Operating income - [operating income x tax rate]

Another way to express this is:

Operating income x (1 - tax rate)

which translates to, using the standard U.S. tax rate:

Operating income x 65%

The tax component is something that no business can escape fully, although it can shield its operating profits with debt. But we want to look at the earnings power of the company and not the efficiency of its tax planning. In assigning a standard tax rate across enterprises, we can judge the operating efficiency of capital without biases on the industry in which the capital is employed. Whether or not we tax operating income, the comparisons across industries will be consistent. The goal is to look at fully taxed operating income. So in this example, the operating income is $376.58, and fully taxed operating income is equal to 65% of that figure, which is $244.78. On a base of $2,600 in invested capital, the company's ROIC is then $244.78 divided by $2,600, or 9.4%.

In short, the formula for ROIC is:

ROIC = After-tax operating earnings / (total assets - non-interest-bearing current liabilities)

There are other ways to look at ROIC, though. Some people would modify the denominator in the equation by deducting goodwill from total assets and non-interest-bearing current liabilities, because goodwill is an intangible asset arising from the purchase of another company at a price higher than the acquired company's appraised net asset value. (Appraised net asset value is usually in the neighborhood of book value.) The company's operating managers don't have use of this asset, so a company with goodwill will look less productive on an operating basis than will a company without goodwill. Therefore, when we look at a company's operating ROIC, we back goodwill out of the ROIC equation, since intangible assets are financial capital, not operating capital.

On the same topic, we always want to back amortization of goodwill out of operating expenses. Since goodwill amortization schedules can differ so much between companies, and since this is a non-cash expense based on an accounting choice that's arbitrary (at least within legally permissible periods not exceeding 40 years), we don't count this is an operating expense. Again, this allows an investor to look at a company's operating performance before taking into account distortions to the cash return that a company is generating.

In fact, cash-on-cash returns are what we're looking for in calculating ROIC. We're trying to look past distortions that come from accounting conventions. Accounting is a rules-based system that allows for a number of choices that can be made by financial managers and approved by auditing firms and distort a company's true economic earnings.

For instance, companies can use certain accounting methods, such as capitalizing expenses, which will increase reported earnings. Analysts focusing on ROIC rather than on just earnings growth, however, have a more useful metric for judging economic profitability. That's because the expenses that were capitalized rather than run immediately through the income statement will show up in the ROIC ratio as a larger amount of capital rather than a smaller amount of after-tax operating income. Using ROIC lets an analyst pay less attention to the accounting choices made to increase reported earnings and devote more attention to the company's cash-on-cash returns.

For more lessons on return on invested capital, follow the links at the bottom of our introductory article.