Return on Invested Capital (ROIC), the topic of our last post “Your Step by Step Guide to Calculating ROIC”, is a fundamental metric for any financial analysis, due to five reasons:
· The ROIC metric is free from the distortion (and crafty earnings manipulation by CFO’s) of financing activities, such as levering up the balance sheet, hiding debt in operating leases, etc.
· The ROIC metric standardizes (to the extent possible) performance across firms allowing for an “apples to apples” comparison between companies or business units within a company
· The ROIC metric can be subsequently decomposed into several value drivers, allowing for insight into future management decisions and granular evaluation of contribution by different organizational functions
· The ROIC metric is directly tied to the firm’s valuation, which is based on discounted cash flows
· The ROIC metric can be used to compare performance to the company’s cost of capital
The Magic of Math
In algebra, we are often given equations which require us to “perform operations” (meaning we can change it) that will make it appear different yet not change the original result.
For example, when given the equation z = x /y, we can modify this using the following lines of thought:
· A variable x is equal to that variable divided by 1, or x = x/1
· A fraction is equal to the multiplication of the numerator and 1 divided by the denominator, or 1/x.
· Any number divided by itself equals 1
Therefore, our ROIC equation, which is ROIC = NOPAT / Capital, can be re-written as (NOPAT / 1) * (1/ Capital). With a 1 in the numerator and denominator, we can use any number in both spots and keep ROIC the same.
From One Ratio to Three
The modified ROIC equation in Figure A thus becomes the product of two ratios, each of which are encountered in the field of finance.
The first term, NOPAT / Sales, is the Net Profit Margin, which answers the question “how much of each sales dollar (or other currency unit) goes to the bottom line?” This is a common question and something helpful to know as we operate our business.
The second term, Sales/Capital, is known as Asset Turnover. This is a measure of how many sales per period are generated by our asset base. A turnover of ²1 means that for each ²1 of assets we generate ²1 in sales (the symbol ² represents Treasury Café Monetary Units, or TCMU’s, freely exchangeable into any currency at a rate of your choosing). A turnover of ²0.5 means that for each ²1 of assets, we generate ²0.5 of sales. A turnover of ²2 means for each ²1 of assets, we generate ²2 of sales.
We can use concepts from calculus to translate changes in these ratios to how that impacted ROIC itself. In other words, these equations answer the question “if the ratio changed by this, then how much did this change ROIC?” These equations are shown in Figure B. This type of analysis is called an “Attribution of Change Analysis”.
In our last post we calculated the Return on Invested Capital for JB Sanfilippo & Son, a Chicago based food manufacturer specializing in nuts by following the traditional method of calculating the ratio by dividing NOPAT by Capital.
Using our ratio approach, we can now break down Sanfilippo’s ROIC into two components, Net profit margin and Total Asset Turnover, and calculate ROIC by multiplying the two.
Finally, we can use the change attribution equations to determine exactly how much ROIC changed due to each of the factors changing.
A good analyst will always seek out ways to verify that what they are producing is accurate and correct. In this case, we can compare the results of our ROIC calculation to that of our prior post in order to see whether there is any difference. And indeed there is not.
These calculations are shown in Figure C. For both the ROIC and attribution calculations, the results are the same as the alternative methods, which should give us great comfort that our algebra has worked as intended!
How This Helps
This methodology of breaking down the ratio into separate components has a number of advantages:
It Provides Explanation – performing the ROIC calculation and reporting that it went from 6.1% last year to 4.1% this year tells us something, but not much. Why did it go down? The basic calculation is silent. But through our ratio and attribution analysis, we know that ROIC went down due to lower net profit margins, and would have declined by 2.4% (Figure C, Item J) had it not been for improvements in asset turnover (Figure C, Item K), which partially offset the impacts.
It Can Answer Follow-Up Questions – given the above assessment, we might be tempted to ask “how much does total asset turnover need to improve to offset the net profit margin decline?” Because we have ratios with several variables and only one unknown, we can use algebra to rearrange the equations in order to arrive at the answer that asset turnover would need to be about 3.1 to have maintained ROIC at last year’s level.
It Allows You to Compare Against Competitors – Figure D shows the ratio and attribution analysis for Diamond Foods, a competitor. Evaluating this, we see that their margins in 2011 were almost 9% compared to Sanfilippo’s 2%. Offsetting this, Sanfilippo’s asset turnover is over twice as good as Diamonds. This can suggest strategy differences, as well as benchmark improvements. If others in the industry are turning assets a lot less often, how much room for improvement is there? Conversely, if margins at our firm is almost 4 times less, how much room might be available by focusing on those items? For Diamond, a strategy on improving turnover, such as a Lean or Six Sigma effort that can lead to reducing the asset base, might yield higher opportunities.
By using a value driver ratio approach combined with a change attribution analysis, we can place better information into the hands of our strategy and operating units which allow them to make better decisions. This places finance in the role of adding value to the enterprise through partnering.
Have you performed a value driver analysis at your firm? How did it turn out?
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