Let’s continue with the ROIC ratio by going deeper into calculating the denominator, or Invested Capital. Should we use items from the left or right side of the balance sheet? You have likely seen both. People have strangely strong feelings about which to use which, from what I can tell come from what they were first taught and ease/speed of use. For example, right side (debt+equity, i.e., how the business is financed) is far easier to set up for screens, as even the most unsophisticated screeners allow the user to pull debt and equity and sum them in a formula. It’s worth stopping and thinking about which to use and why, and Mauboussin provides a great discussion of this topic beginning on page 5 of Calculating Return On Capital:
“You can think of Invested Capital in two ways that are equal. First, it’s the amount of net assets (left side of B/S) a company needs to run its business. Alternatively, it’s the amount of financing (right side of B/S) a company’s creditors and shareholders need to supply to fund the net assets. These approaches are equivalent since dual-entry accounting requires that both sides of the balance sheet equal one another.”
Mauboussin goes on to call the left-side version the Operating Approach and the right-side version the Financing Approach. Here’s how it sets up:
Operating Approach
Invested Capital (Net assets)
--------
Current assets (taking out excess cash)
- Non-interest bearing current liabilities
--------
= Net working capital
+ Net property, plant, and equipment
+ Goodwill & other intangible assets
+ Other operating assets
--------
= Invested CapitalFinancing Approach
Invested Capital (Liabilities + Equity)
--------
Short-term debt
+ Long-term debt
--------
= Total debt
+ Deferred taxes
+ Other long-term liabilities
+ Preferred stock
+ Shareholders' equity
--------
= Total Equity
= Invested CapitalAs you can see, the Operating Approach is using (GAAP) assets, backing off current liabilities (because they are essentially a free form of financing those short-term assets such that only the net amount is actually “invested”), and adding long-term assets to get to Invested Capital. The Financing Approach basically uses the accounts that are used to finance those assets – debt, equity, and some other kinds of long-term liabilities.
Why To Use The Operating Approach
As Mauboussin says on page 5 of Calculating Return On Capital:
“The reason is that the net assets approach (aka Operating Approach) allows you to see how efficiently the company is using capital. In contrast, the right-hand side (Financing Approach) shows only how much capital the firm has and how it has chosen to finance the business.”
This makes a lot of sense to me – the whole point of the ROIC exercise is to examine the return a business generates from operating assets, so why not use them directly in the ROIC calculation.
The Operating Approach forces you to think through the appropriateness of the individual line items that sum up the invested capital rather than the broad buckets for how they were financed, which is always a good idea, since ultimately we are really just trying to understand how the business works and how it may/may not work in the future. If you want to understand the quality of a sausage business and its earning power, is it better to study the sausage plant (among other assets), or the mortgage on the sausage plant? I think the former.
In practical terms, the Operating Approach helps you avoid calculation and analytical mistakes (i.e., errors of omission or inclusion in calculating invested capital) that you might make if you just mechanically applied the Financing Approach. For example:
- Excess Cash – What if the company has a lot of it? A good example of this was Microsoft at different points over the years. It’s not an “operating” asset, so it should be mostly excluded from invested capital. But if you were looking at just the right side of the Balance Sheet (i.e. debt and equity) you would be overstating the amount of capital invested in operations. On the other hand, if you were using ROIC to analyze management’s effectiveness you might want to capture cash, as shareholders have entrusted management with that asset too and they are accountable for generating returns with it
- Preferred Stock/Other Forms Of Financing – If you just wiz through the right side of the balance sheet pulling out debt and common equity (like many screens do) you might miss some of these and understated invested capital. A lot of screens are guilty of this mistake.
- Equity Method/Minority Investments – These are on the left side of the Balance Sheet and are not operating assets, so they need to be excluded. But if you look only at debt and equity on the right side, you’ll likely forget to exclude this and overestimate invested capital.
There are many more examples of specific items that need to be dealt with correctly. But the bottom line is that using the Financing Method makes you more likely to misjudge the underlying level of operating assets that the business is using, which makes your ROIC results fairly useless. So stick with the Operating Approach.