<SPECIAL FEATURE>
April 20, 1999
Cash's Role
By
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 that I will address 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.
</SPECIAL FEATURE>
In Part 2, 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 capital and ROIC put forth in the Parts 2 and 3. The invested capital base is total assets minus non-interest-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 non-interest-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. I stand by this definition depending on the application. For instance, when I wrote about Washington, D.C.-area brokerage and investment banking firm Friedman, Billings, & Ramsey Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FBG)") else Response.Write("(NYSE: FBG)") end if %>, I made a distinction between financial capital and invested capital. This was meant to parse the company's performance on capital that it had actually deployed in its business from the huge amount of cash that was sitting on the sidelines waiting to be invested.
Another case where there was a huge amount of uninvested capital was DSP Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DSP)") else Response.Write("(NYSE: DSP)") end if %>. That company's return on invested capital (assessing ROIC by the most recent definition above) was huge, but its return on all capital invested in the business was much smaller. The most conservative way to look at the company's ROIC performance was to look at ROIC using a capital base that didn't deduct the idle cash. That's because the company apparently could not find outlets into which it could invest that extra cash. If one were to judge the company on the huge ROIC with a capital base that didn't include the cash, one would have bought DSP all the way up to its high. That's a lofty perch that DSP now sits far below.
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 as excess capital. For instance, Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> has at various times had a bunch of cash on the balance sheet, but that doesn't mean that we would consider that to be excess cash that an acquirer of the company could take 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. Boeing <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BA)") else Response.Write("(NYSE: BA)") end if %> or General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %>, 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 non-interest-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 or Barron's Roundtable sorts of people look at GM 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.
A company such as GM needs a bunch of cash (8% of revenues) not just to weather business downturns and interruptions such as strikes, but because it takes longer to convert cash into inventory into revenues and back into cash again. On the other hand, a company that turns its cash into inventory into revenues into cash very quickly, such as Costco <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COST)") else Response.Write("(Nasdaq: COST)") end if %>, needs less cash to operate. In that case, any cash that it carries beyond 5% of revenues should be deducted from its capital base. Finally, in the case of Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>, in which the concepts of gross margin and cost of revenues are largely irrelevant (thus, inventory needs are nonexistent), all cash should be deducted from the capital base.
As a compromise, this can work better and be more flexible than the very hardcore definition of invested capital that I put forth in the original series. Some businesses such as Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> 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. So, in the case of Intel, its high ROIC reduces the days of sales in cash that it needs to hold, but it doesn't reduce it to zero. 5% of sales in cash is probably a prudent level of cash to hold and anything beyond that can be deducted from the invested capital base.