Let’s Geek Out! What’s your ROIC and ROA?

One of my favorite management truisms is “what is measured gets managed”. In our industry, it seems that daily there is a new metric to be managed. Whether it is cycle time, rental days, repair vs replace, severity, or refinish hours, this is an industry dominated by operational metrics.

But for all of our focus on operational metrics, there is surprising less focus on financial metrics, and almost no focus on balance sheet metrics. While the industry focuses on operational metrics, the financiers of the world focus on an entirely different set of metrics.

Two important metrics that are easy to look at are ROIC and ROA. ROIC stands for Return on Invested Capital. ROA stands for Return on Assets. ROA tells us how efficiently a business uses its existing assets to generate profits. ROIC tells us how effective a business is in re-investing in itself. So what’s your ROIC and ROA?

Why are these important? Aside from the obvious that these metrics determine how well you are running and investing in your business, when it comes time to exit your business and maximize your valuation, being able to demonstrate strong ROIC and ROA will help lower your perceived risk by increasing the clarity around your future cash flows. Plus it demonstrates professional management.

Return on Assets (ROA)

Return on Assets is simply the profit that all of your business assets generate in a given year. The higher the percentage, the more efficient your assets are. Traditionally, the formula for ROA is simply Net Income ÷ Total Net Assets (Total Net Assets are Total Assets after depreciation). But since Net Income varies from company to company due to different capital structure, tax structure, and other corporate financing decisions, I prefer to use operating profit, or EBIT, in place of Net Income. To calculate your operating profit, start with your net income, add back interest expense, tax expense, and any non-operating expenses.

Using Boyd and an example, operating profit in 2015 was $73 million. Total Assets were $639 million. ROA in 2015 was $73 ÷ $639 = 11.4%. By comparison, in 2014 Boyd’s operating profit was $48.5 million and Total Assets were $488 million for an ROA of 9.9%. What was your ROA last year? Shoot me an email and let me know.

Return on Assets is often driven by the capital intensity of the business. The greater the fixed assets required to operate the business, the lower the ROA tends to be for companies in that industry. While in the past the collision repair industry was relatively asset light compared to other industries, this is changing due advanced vehicle construction materials and increasing OEM tooling requirements in the industry. Going forward, I believe ROA industry wide will gradually decline due to increasing capital and tooling requirements.

Return on Invested Capital (ROIC)

Return on Invested Capital measures the profit your business generates as a result of re-investing back into the business. In short, the return for every dollar invested into the business. Similar to ROA, there are multiple ways to calculate the formula. It is a bit more complex of a formula than ROA, but one I find very useful.

What I find most useful about ROIC is that it looks at all the resources invested into a business – both debt and equity. A common, often unfounded, critique of private equity backed and publicly traded companies is that they are successful only because they have “Wall Street money”.  Looking at ROIC tells us if a company is efficiently investing and generating returns with the money provided by various banks and other financial partners. In a privately held businesses ROIC tells us if the investments made into the business are actually making money. In financial speak, is the company generating a return in excess of its cost of capital.

The simplest way to calculate ROIC is to divide Operating Income by the sum of total debt and equity in the business (technically we want NOPAT, Operating Profit after tax, but let’s leave that for the aside for now). In other words, to divide Operating Income by the total amount of money invested into the company (debt and equity). Total debt and total equity are easy to find – just take a look at your balance sheet and both are listed.

You can also use ROIC to look at specific investments as well. For example, say you acquire another business. To calculate the ROIC for that investment you would divide total operating income at the acquired business by the total amount invested to acquire the business, including any debt you took on for the acquisition.

For example, say you acquired a business for $1.6 million dollars last year, and that this year it generated $4 million in revenue, and $400,000 Operating Profit. ROIC for this investment is an attractive 25%. By comparison, Boyd generated a pre-tax ROIC of 18.4% in 2015. In fact, here is Boyd’s ROIC for the past 5 years.

ROIC

You probably noticed I included 3 different ROIC formulas. Depending on your needs, there are a number of ways to calculate ROIC. Instead of looking at debt and equity, you can look at fixed assets and net working capital. You can look at EBITDA instead of EBIT and factor in gross fixed assets before depreciation instead of net fixed assets after depreciation. You can look at NOPAT, or net operating profit after tax if you are comparing ROIC to the cost of capital of the firm. But, for our purposes, the simplest approach is Operating Income (EBIT) ÷ Total Capital (the last one on the list). As always, email me if you want to geek out to discuss why there are different equations and when they are appropriate to use.

Acquisitions Make Financial Sense

The reason that so many acquisitions are taking place in the automotive industry is that they make financial sense. Where else can you invest your money and generate a 25% pre-tax return on investment? And when you take into account deal structuring, the returns on equity can be substantially higher. It’s no wonder the larger consolidators continue to scoop up smaller operators in the market.

If you are interested in putting your capital to work, shoot me an email. There is a lot of opportunity in the industry for those with the appropriate time horizon.

Until Next Week!

Increase the value of your business. Sign up and get my weekly notes straight to your inbox. I keep your email private and do not share your info. Easily unsubscribe at any time.