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April 20, 1999
An Example
By
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As we said in the first part of this series, return on invested capital is somewhat like return on equity (ROE), but it improves upon it. In the example we set forth, we modified the amount of shareholders' equity assumed to be in use by management because Generally Accepted Accounting Principles (GAAP) can understate the amount of resources that a company currently has at its disposal. That, in turn, can overstate the company's return on capital and lead to an investor misjudging the performance and economics of a business he or she is analyzing.
Return on invested capital leaves ROE in the dust for a number of reasons. First, ROE takes as the invested capital base just the residual of assets minus liabilities. An investor might think that a 15% return on equity is an acceptable return in all circumstances, but one has to look at the leverage and return on all capital before making the judgment that equity is safe.
Take this example using these average balance sheet amounts:
Total assets...$3,000
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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
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A company generating earnings of $112.50 during the fiscal year would run a nominally great return on equity of 15%. An investor might be very pleased with that performance. Another way of looking at it, though, compares earnings to all capital invested in the business, which is all long-term and short-term capital -- 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 (this work is also backed up by a heck of a lot of practical application on the part of Stewart and his partners at Stern Stewart & Co., so this isn't just propeller-head stuff). You can add up the capital in use by a firm 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 is where assets are found. Remember, assets minus liabilities equals owners' equity -- the bottom line on a balance sheet. Rearranging the equation, though, gets us to an expression of how all assets are funded on a balance sheet: assets = liabilities + owners' equity.
So, we can calculate invested capital as being equal to all financial capital. We can also look at it starting from the asset side. Start with all assets and deduct non-interest bearing current liabilities. In the above case, we deduct from total assets of $3,000 non-interesting bearing current liabilities of $400. The liabilities of accounts payable and accrued compensation expenses do not represent capital invested in the business by either equity or debt holders. While they are debt under the most stringent forms of looking at the balance sheet, they don't represent invested capital. 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 is going to operate with an average level of these liabilities all year long. The value of work that an employee renders is found in inventory, if the company is a traditional manufacturer. Since many people are paid on a bi-weekly schedule, the value that the employee renders in labor between paydays is accrued. It's pretty much an interest-free short-term loan of labor.
Either way of looking at it, we have $2,600 in invested capital. Now we have to adjust the return before dividing it into invested capital to calculate ROIC. The net income figure that is used in the calculation of return on equity is not directly analogous to the "return" in ROIC. That's because 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. 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. Don't worry, we're not ignoring leverage here. We'll consider the cost of capital later in this series.