Expert: Gina Boykin - 3/28/2008

Question
QUESTION: Hi Gina! The formula i have for ROIC (return on invested capital) is Net Operating Profit after Tax/(Total Assets- Cash-Long & Short Term Investments - Current NonInterest Bearing Liabilities). I am having problems understanding why we subtract current non interest bearing liabilities from the total assets? What is the logic? I mean we are interested in how much our invested capital is returning why  do the current liabilities matter?

ANSWER: ROIC is somewhere between ROA (return on assets) and ROE (return on equity).  In ROE, the denominator is equity (assets - liabilities).  In ROA, the denominator is assets (no subtractions).  In ROIC we only subtract non interest bearing liabilities.  Non interest bearing liabilities (like deferred taxes and accrued expenses) are not really the same as loans (which have interest).  These things are calculated based on assumptions and expectations, rather than an obligation to pay borrowed money back.  For example, a company may accrue for possible exposure on a lawsuit that may end up eventually closed without any cost to the company.  With this example, you can see how this is not the same as debt.

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QUESTION: Its very clear as to what ROE and ROA tell me when analyzing a business. But what i dont understand is exactly what does ROIC tell me when i analyze a particular business. What is the logic in subtracting Non interest bearing liabilities to that extent. I mean I know they say that ROIC helps in determining how much returns a business generates from its "core operations" and thats why we subtract cash and long term investments from the denominator. But subtracting Non interest bearing liabilities, is that not part of a business' core operations in the form of expenses? I thnk my basic understanding of a business' balance sheet is very weak. Thanks for taking the time.

Answer
When you record a liability, the other side is usually an expense. However, that does not mean that the expense requires cash payment.  Deferred tax liability, for example, is not a liability that will be paid in cash in the following period. Some accruals are recorded for financial statement purposes, but may not end up in cash being paid (like the legal accrual example I gave before).  All interest bearing liabilities are debts that require cash payments to be made in the future and therefore are a part of the "core operations" you referred to.

When you look at ROIC, you're taking out some of the things on the financials that have value, but don't have anything to do with the actual operations of the business.

I've actually never used ROIC to analyze a business before, for investing purposes or when auditing a company, so I cannot say how useful it is.