Recently, I was working with a client. The purpose of the project was to evaluate the business, and some recent investments the client made. On the surface, the investments appeared to be highly profitable. They were yielding very strong EBITDA margins. So strong in fact, the analysis seemed almost after the fact. With such strong margins, of course the investment made economic sense. But then we looked at the ROIC.
ROIC, or return on invested capital, measures the return the business in generating, after taking into account all the investments required in the business. Effectively, ROIC is the ROI of the business as a whole. It is a metric, that while very important, often is overlooked by many business owners.
ROIC at first glance may not be immediately intuitive to many. It is a metric, like EBITDA, that does not appear on a standard income statement or balance sheet. It also requires calculations of multiple line items found on both the balance sheet and income statement. And the formula can be deconstructed to derive additional insights, further adding to the appearance of complexity (more on that in a later post).
But ROIC is powerful, and actually quite intuitive once you get past the arcane accounting language!
Why Use ROIC?
A key aspect in evaluating the effectiveness of a management team is to assess how well they put capital to work. In other words, do they make wise investment decisions when it comes to their own business. Or are they profligate gamblers, throwing money, time and resources at any project that looks attractive. Evaluating ROIC is one metric that helps management teams assess past investments, and helps them make better future capital allocation decisions.
Personally, I find ROIC a useful metric because it looks at the totality of investment made into a business relative to the profits it generates (I’ll discuss how to calculate ROIC below). ROIC uses an accounting term called NOPAT to evaluate return. NOPAT starts with net income, removes non-cash D&A expenses and effectively normalizes the numerator to approximate cash flow in a more comprehensive manner than relying upon EBITDA alone (more on that below). NOPAT excludes interest expense, but includes the tax impact on operating profits, thus providing an alternate approach to EBITDA when approximating cash flow. My favorite aspect of using ROIC as a management tool is that because ROIC takes into account all invested capital, capital budgeting, working capital and capex decisions are factored into the return analysis! (yes, I added an exclamation point to this sentence. I tend to get very excited about financial analysis).
What Is ROIC?
Formally, NOPAT divided by Invested Capital. NOPAT stands for Net Operating Profits After Tax. Invested Capital is the sum of both debt and equity invested into a business.
You won’t find a NOPAT line or Invested Capital line on a standard P&L or Balance Sheet. But both are easily calculated. NOPAT is simply after tax operating profit, or EBIT * (1-tax rate). Invested Capital is total equity plus total debt less any excess cash held in the business.
ROIC effectively measures the return on total investment a business generates. Total investment, or total capital can take many forms, equity, debt, working capital, and even vendor financing and pre-bates. Put simply, ROIC helps answer the question of how effectively is management converting their investments into returns. ROIC is to the balance sheet what net profit is to the P&L.
NOPAT vs EBITDA
A common criticism of relying upon EBITDA to evaluate the cash flow of a business is that interest and taxes are true cash costs. Additionally, depreciation and amortization are also cash costs, but from prior periods. And EBITDA alone does not include the impact of working capital and projected capex.
EBITDA evaluates the cash flow available to a firm, independent of financing and investment decisions. Academically, and in many cases practically, that analysis is proper. But for many, that simply may not be an appropriate way to evaluate a business. ROIC takes into consideration some of these concerns.
In the case of the client I mentioned at the beginning of the article, we assessed the projected ROIC for his project. From an EBITDA standpoint, the project was a home run. But we were surprised to find that the project substantially decreased the overall ROIC of the firm. While the project had great margins, it required a substantial initial investment, financed 100% with debt. While cash flow positive due to the high margins and high non-cash depreciation expense, the projected incremental revenues and cash flows were too small to offset the large initial investment. As a result, pro forma ROIC dropped from the very high teens to the mid-single digits. In fact, the project returns did not meet the firms weighted average cost of capital (WACC), and actually had a negative NPV. This was a poignant reminder that it is prudent to evaluate all major invest decisions, even those with high margins that seem to carry little to no risk. Thankfully the client is well on the way to significantly outperform plan and the project will generate a positive return.
Tying it Together
There is no one perfect tool to evaluate an investment or the health of a business and ROIC is just one of many. Ultimately, whether assessing an acquisition, determining the effectiveness of an investment decision, or evaluating a management team comes down to comprehensive and thorough analysis of multiple factors.
I want to help you make good investment decisions. Whether that is analyzing an acquisition, evaluating an expansion, or simply providing strategic guidance, my team is here to help. Use my contact page, drop me a line, become a customer, and let’s make great business decisions together. Subscribers, simply hit REPLY. I always enjoy speaking to folks in an industry that I am passionate about.
Until next week!