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Testing effective use of capital: ROE and ROIC

December 20, 2016

By Frank Luengo, Sonora Foods Ltd. 

I recently reviewed my preferred ways to arrange a balance sheet and income statement to facilitate ratio analysis. Today I want to cover the basic ratios that show how well a business is utilizing the capital it manages.

The first is return on equity, which can be defined as:

ROE = Net Income / Shareholder’s Equity

Most textbook definitions of this ratio will take the average shareholder’s equity between the current one-year period and prior period. This assumes that the end of year income was generated from a combination of prior period earnings and the current earnings accumulated throughout the year.

My view is slightly different. I believe that a business is given a certain amount of equity at the beginning of the period and must provide a return on that equity during the period. For example, if I provide a business $100 at the beginning of the year and I expect a 10% return on my equity, I expect the business to have $110 in equity at the end of the year: $100 in stock, and $10 in current earnings (net income for the period). Using the average shareholder equity method would yield a return of:

ROE = 10 / ( (110+100)/2) ) = 10 / 105 = 9.5%

This is counterintuitive since I’m comfortable that the return is in fact 10%.

For this reason, I update the formula as follows:

ROE = Net Income(t) / Shareholder’s Equity(t-1)

That is, for this one-year period’s earnings (time t), I divide against the equity available in the prior period (time t-1).

The second ratio which needs to be utilized in conjunction with ROE is ROIC, or return on invested capital. This is important because, as a firm increases leverage, their return on equity will increase. However, increasing leverage is not necessarily a desirable change to the firm’s capital structure. One way of rounding out this analysis is to see how the firm is doing with all the capital that it is supplied, including debt.

ROIC is defined as follows:

ROIC = Net Income / (Shareholder’s Equity + Debt)

Once can view this ratio as a test of the whether the firm is providing a rate of return on its capital which exceeds their weighted average cost of capital. If the firm’s ROE increases but ROIC decreases during a fiscal period, it may be due to a changing and more levered capital structure.

Also note that the value of debt can be either the book value of debt or a calculated net present value of debt, based on all debt outstanding. I use book value for my own analysis, but this is not adequate when performing formal valuations of firms.

Lastly, if the firm’s capital structure includes preferred shares, they must be added to the denominator in the ROIC calculation.

This article was written by Frank Luengo, originally published on Frank’s Vault.