Return on Invested Capital (ROIC) is used to measure the company’s efficiency to allocate capital. The formula for ROIC is
ROIC = After Tax Operating Income / Invested capital
Don’t worry if you did not understand the formula. I did not either. I started with the question Why do we need ROIC? We already have Return on Assets (ROA) and Return on Equity (ROE). Let us understand what ROA and ROE is and see what facts they do not reveal. Then we will explore in detail about ROIC and see how it fills that gap.
I imagined myself being an owner of a Software consulting company. I am the only employee in the company. Given below are the company Balance Sheet and Income Statement for the year 2012.
Balance Sheet as of 31-Dec-2012 Assets Cash in Hand : $20 -- Checking Account at 0% Computer and Equipment: $50 Investments : $30 -- Surplus invested in short term Govt bonds. ---- Total Assets : $100 ---- Liabilities Amount owed to suppliers: $30 -- No need to pay interest(Accounts Payable) Long Term Debt : $10 -- Loan @50% per annum --- Total Liability : $40 --- Income Statement for the Period Ending 2012 Revenue : $100 Expenses : $60 Gross Income : $40 Depreciation : $5 -- Straight line for 10 years(50/10) Operating Income : $35 Interest Expense : $5 Interest Income : $1(Interest earned from investments) Income Tax @9.67% : $3 --- Net Income : $28 ---
Let us calculate the ROA.
ROA = Net Income/Total Assets ROA = $28/$100 ROA = 28%
Let us calculate the ROE.
ROE = Net Income/Equity How to calculate Equity? Assets = Liabilities + Equity Equity = Assets - Liabilities Equity = $100 - $40 Equity = $60 ROE = $28/$60 ROE = 46.67%
What is the issue with ROA?
The total assets used in calculating ROA is $100. ‘Cash in Hand’ and Investments are not employed in generating the operating earnings for the business. Including it in the equation reduces the return. Why? If the denominator is higher then the return will be lower.
Cash in Hand : $20
Investments : $30
What is the issue with ROE?
It calculates the return earned by the share holders. In this example I am the only shareholder and the equity is $60. It does not include the Debt. By taking a lot of Debt the ROE can be increased substantially without any improvement to the underlying business. Why? Taking a lot of Debt decreases the Equity which is in the denominator and hence the return will be higher.
ROIC to the rescue
We need to find out how to compute ‘Invested Capital’ and ‘After Tax Operating Income’
ROIC = After Tax Operating Income / Invested capital
Invested capital is the money invested in the business to generate the operating earnings.
Invested Capital = (Total Assets - Excess Cash - Investments) - (Non Interest Bearing Current Liabilities) = $100 - $10 - $30 - $30 = $30
Why do we need to subtract Cash and Investments
Some of the the cash and investments might not be directly used in the business and hence we should not include it in the invested capital. In this example the business only needed $10 from cash.
Why subtract ‘Non Interest Bearing Current Liabilities’
The company purchased ‘Computers and Equipments’ for $50 and it owes $30 to the suppliers. Remember we did not pay any interest for the amount owed. It is free money (float) which is invested in the business by our suppliers (Other People Money;no cost).
Why add ‘Long Term Debt’
This is not free money and the company is paying interest and hence we need to add it.
After Tax Operating Income is computed as given below
After Tax Operating Income = Operating Income * (1 - taxRate) = $35 * (1 - 9.67%) = $35 - 3.38 = $31.62
Why is Interest Income of $1 not considered in the operating income
Remember these are not earned by the actual business. They are earned by investing our surplus cash.
Is it necessary to take income tax rate into account
I prefer taking Pre Tax Operating Income. The reason is because the tax situation is different for some industries. Also taxes are complicated!
Now we calculated both the After Tax Operating Income and Invested Capital, let us complete the puzzle.
ROIC = After Tax Operating Income / Invested capital ROIC = $31.62/$30 ROIC = 105.40%
ROIC measures business efficiency
- ROIC counts only assets and liabilities that are employed in generating operating earnings for the business. It removes the rest. It is not skewed by how the company is financed.
- Great businesses have very high return on capital.
- The software company which I imagined, is an excellent business as it generates 105.40% return on the invested capital.
If you want to increase the odds of being successful in investing, it is better to own business which has high returns on capital. Also ensure the business has a Moat. Excerpt from Berkshire 1988 letter
Take the breakfast cereal industry, whose return on invested capital is more than double that of the auto insurance industry (which is why companies like Kellogg and General Mills sell at five times book value and most large insurers sell close to book). The cereal companies regularly impose price increases, few of them related to a significant jump in their costs. Yet not a peep is heard from consumers. But when auto insurers raise prices by amounts that do not even match cost increases, customers are outraged. If you want to be loved, it’s clearly better to sell high-priced corn flakes than low-priced auto insurance.
All numbers are in millions. Assets Inventories - 6,031 Receivables - 3,364 Property and Equipment - 7,060 ------ 16,455 ------ Current Liabilities Accounts Payable - 13,318(no interest)
Amazon invested 16.45 Billion in the Business and 13.31 Billion is being funded by the Suppliers free of cost. Hence the total invested capital is 3.13 Billion(16,455 – 13,318). How can they do this? Excerpt from the Annual Letter
Because of our model we are able to turn our inventory quickly and have a cash-generating operating cycle. On average, our high inventory velocity means we generally collect from consumers before our payments to suppliers come due. Inventory turnover was 9, 10, and 11 for 2012, 2011, and 2010.
I looked at the Income Statement for the same year and Pre Tax Income from Operations is 676 million.Hence the return on capital comes to 21.54%(676/3137).
Why did I deviate from the original ROIC formula for Amazon?
Formula is just a guide and not the rule. Looking at this way helps me to understand Amazon’s command over its suppliers.
Last evening I had Burrito at Chipotle. I decided to look at its financial statement for the year 2012.
All numbers are in millions Total Current Assets - 546.00(+) Cash and Investments - 472.86(-) Property Plant and Equipment - 866.70(+) Accounts Payable - 186.70(-) Long term liabilities - 216.00(+) ------ Invested Capital - 969.14 ------ Pre Tax Operating Income - 455.00
The pre tax return on invested capital comes to 46.94% ($455.00 / $969.14). So much of return for making Burritos!