One of the ways to assess the quality of a business is to look at its historical return on capital. Although there are various ways that investors calculate return on capital, the one that I use is:
Return on capital = Operating income (EBIT) / Invested capital
In addition to assessing the quality of a business, the change in invested capital year on year also provides a measure of the reinvestment needs of a business when computing free cash flows.
Needless to say, computing the right invested capital base then becomes important in the assessment of any business and valuation.
But, do we calculate invested capital in the right manner?
I am going to divide this post into two parts. In part 1, I am going to discuss some of the nuances of computing invested capital and adjustments that may be required when computing this seemingly simple looking number.
In part 2, I will discuss why I feel it may be a better guide (if computed right) of what companies have to reinvest back into their business to generate growth rather than going by the more popular “Net Capex + Change in working capital” method of computing reinvestment.
What is invested capital?
Before I get into the definition of invested capital, let’s first take a look at a simplified balance sheet of a business:
Traditionally, we have all been taught that invested capital is:
Invested Capital = Book Equity + Book Debt - Cash
Based on this definition, the invested capital base would be:
Invested capital = 175 + 50 - 25 = 200
However, as is often the case, reality is not as simple. We need to make the following adjustments in order to compute the right invested capital base of a business.
- Adjustment for Non-Operating Assets;
- Adjustment for Goodwill/ Accounting Write-Offs; and
- Adjustment for Other Comprehensive Income.
Each of the above adjustments is discussed in detail in the following paragraphs.
Adjustment for Non-Operating Assets
In our above example, let’s assume that there were non-operating assets of about $25 out of the total other assets of $50. The balance sheet would look something like this:
At the beginning of the post, I mentioned that to assess the quality of a business, we look at its historical return on capital and that the Return on capital is EBIT/ Invested capital. Essentially, e are trying to figure out how much does the business earn relative to how much cash is invested into the business. We remove the cash on the balance sheet to compute invested capital since we assume that most of it is excess cash, i.e. not required for the day to day running of the business. Going by that logic, we should treat non-operating assets the same way since EBIT does not include the return being generated by those non-operating assets. Accordingly, the invested capital equation should be modified to:
Invested capital = Equity + Debt - Cash - Non-operating assets
In our example, it would mean that the capital invested to run the day to day operations of the business is $175 ($200 – 25$) and not $200 as computed earlier.
Accounting write-offs
It is amazing how often managements try to project a rosier picture for shareholders when in fact, quite the opposite is true. One such instance is when managements take write-offs of previous bad investments.
Their argument goes something like this:
“We have decided to take a $x write off; Oh but wait, don’t be sad since it is good for you, dear shareholder; Let us explain – this is a non-cash write-off so you should ignore it and the write-off will lower our invested capital base which will allow us now to earn an adequate return on invested capital.”
Let’s deal with the “non-cash write off” argument first. It is technically right that the write-off is non-cash in the current accounting period. It just so happens that real cash was spent in some earlier period and management’s return expectations from those investments have not come to fruition, hence the write-off.
Now coming to the “it will allow us to earn an adequate return” argument. Well, this is just plain silly. Imagine you lend someone $100 and agree to a 10% interest rate. You expect to receive $10 at the end of the first year. However, at the end of the year, the borrower comes back to you and says,
“oh, I am sorry but the money you lent me, I can now only pay $5 as interest on it instead of $10 we agreed to earlier. But wait, it is ok since we will just take a write off of $50 in our books and imagine that you lent me only $50 to begin with. That way, I can still pay you a 10% rate of interest!”
This is exactly what managements mean when they say that a write-off will allow them to earn an “adequate” return after the write-off. As far as shareholders are concerned, some of their real money was spent on these investments which are now being written off because of unmet expectations.
Dealing with write-offs
Having cleared this up, let’s move onto the implications of a write-off and how we should deal with them when computing invested capital.
A write-off lowers the equity on the balance sheet by the amount of the write-off not just for the current year, but also for all future years. Given our invested capital equation, a lower equity means a lower invested capital base.
We should simply add back the write-offs to not only current year’s equity but also to all future years. This basically means that you have to add the cumulative write-offs of previous years to the equity stated on the balance sheet each year. We are trying to achieve something similar to a Gross PP&E account where the write-offs act as Accumulated Depreciation to figure out the total amount that has been invested (and remains invested) as shareholder’s equity in the business to date.
For instance, let’s assume that current year’s income statement is as follows:
In the current year, net income of $10 was transferred to the equity account in the balance sheet. However, this net income is after a one-time write-off of $25. If that write-off had not occurred, the amount that would have been transferred to the equity account would have been $35 ($10 + $25). Hence, the equity account is understated by $25.
That was for the current year. Let’s think about next year’s balance sheet. The balance sheet is a snapshot of the company’s financial position at a given point in time and encapsulates whatever has happened to the company since its beginning up to the date of the balance sheet. In next year’s balance sheet, the equity account would still be understated by $25. Hence we need to add it again!
We need to rewrite the invested capital equation as follows:
Invested capital = Equity + Debt - Cash - Non-operating assets + Cumulative write-offs
Hence, our invested capital will now again be $200 ($175 + $25 for the write-off assuming this was the first write-off in the history of the business).
Other comprehensive income
Now we come to one of the black boxes of the financial statements that nobody wants to look at (including myself)!
For all public companies, there is a statement below the normal income statement which is called the “Other Comprehensive Income”. There are 4 types of transactions that are essentially recorded in this statement:
- Unrealised holding gains and losses on investments that are classified as available for sale;
- Foreign currency translation gains or losses;
- Pension plan gains or losses; and
- Pension prior service costs or credits.
These reflect gains and losses that have not been realised yet, i.e. no cash has been exchanged and generally don’t belong to the day to day operations of the company. To record them, they are directly adjusted in the equity reserves (through a reserve called the Accumulated Other Comprehensive Income Reserve) without impacting the normal income statement.
Refer to this link for a better understanding of Other Comprehensive Income.
The treatment of other comprehensive income is similar to accounting write-offs. Fortunately though, unlike accounting write-offs, we do have the cumulative position of these adjustments over the life of the firm and we can simply add/ subtract the “Accumulated Other Comprehensive Income Reserve” from Equity to make a better assessment of the capital invested in the business.
Our invested capital equation now looks something like this:
Invested capital = Equity + Debt - Cash - Non-operating assets + Cumulative write-offs - Accumulated Other Comprehensive Income Reserve
Let’s say that the total accumulated other comprehensive income reserve is $10 out of the total equity of $175, i.e. operating equity is overstated by $10. Accordingly, our invested capital will now be $190 ($200 – $10 of accumulated other comprehensive income reserve).
Some other adjustments
As if the above adjustments were not enough, we can go one step further to adjust the invested capital to make it comparable between different companies. For instance, think of two retail business:
- Firm 1 has a strategy to own its properties;
- Firm 2 rents its properties.
In order to make the two companies comparable, we might have to capitalise the operating leases of Firm 2 (something that the accounting standards are going to do 2019 onwards). This adjustment will make a difference to the invested capital base of the firm whose leases are being capitalised.
Similarly, we can capitalise certain expenses which are in effect meant for long term growth of the company (e.g. R&D expenses) but are fully expensed as per current accounting rules. This adjustment too, will have an impact on the true invested capital base of the company.
Rather than take you through the mechanics of how these adjustments are made, I’ll simply direct to two papers on this matter by Prof. Damodaran. Suffice to say, these are the best resources on this subjects that you will find anywhere and I wouldn’t even dare to think that I could explain them better than Prof. Damodaran!
Paper on operating leases;
Paper on capitalising R&D expenses.
Conclusion
In this post, I looked at some of the practical aspects of computing the true invested capital base of a company in order to assess its quality.
In the next post, I will look at why the change in invested capital year over year may be a better reflection of the reinvestment requirements of a business rather than taking the capital expenditures and changes in working capital from a company’s cash flow statement.
Until next time!