& Other Intangible Assets
– Accumulated Amortization
Applying the same process to the Liability side of the Balance sheet:
[1-25]Total Liabilities + TSHE = Total Current Liabilities + Long-Term Debt
+ Total Shareholders' Equity
Current Liabilities consists of Accounts Payable,14 which is money the company owes its suppliers, Taxes Payable, and Short-Term Debt, which is interest-bearing debt that has to be repaid in less than one year.
[1-26]Total Current Liabilities = Accounts Payable + Taxes Payable
+ Short-Term Debt
Long-Term Debt is interest-bearing debt and has a tenor of more than one year before it has to be repaid or rolled over.
Total Shareholders' Equity is the sum of the money the company took in when it raised capital by selling shares in the Company to investors and Retained Earnings, which is the sum of all the profits and losses of the Company since inception minus any dividends that have been paid.
[1-27]Total Shareholders' Equity = Paid-in Capital + Retained Earnings
Return on Capital Employed
Management teams perform better if they are measured against some set of criteria. One of the criteria that is of interest to investors is the return provided by funds invested in the business. A measurement of this is “Return on Capital Employed.” The classical definition for Return on Capital Employed (ROCE) is:
[1-28]
where:
NOPAT = Net Operating Profit after Tax and CE = Capital Employed
Before Equation [1-28] can be used it's necessary to define NOPAT in terms of Income Statement terminology. The Income Statement in Table 1-1 has several line items such as EBITDA, EBIT, and EBT that state income at different levels. EBITDA and EBIT are clearly operations oriented. EBT is not, because it would include the impact of any interest expense or income. Interest is a result of capital structure (Debt the company takes on to its balance sheet) or interest income generated by any excess cash and isn't operating income per se. Therefore, the income classification that states the Operating Profit is EBIT. To comply with the definition it has to be tax affected, hence the expression for ROCE becomes
[1-29]
or
[1-30]
In a general sense, managers are tasked with two key objectives: (1) Find attractive investments, and (2) deliver attractive returns. Since ROCE compares what management delivers (Net Operating Profit after Tax) to what has been invested in the company (Capital Employed), ROCE is a key measure of how well management is performing and is often used in the annual evaluation process of management teams.
Capital Employed
Capital Employed (CE) can be defined with the assistance of the Balance Sheet (Table 1-3).
By definition, the Capital Employed in a business is the capital provided by equity holders and holders of equity-like instruments, earnings retained in the business, and interest-bearing debt (such as bank loans, bonds, private placements, and so on). Liabilities such as Accounts Payable and Taxes Payable and so forth are not considered as Capital Employed because they do not result in any financing cost to the company.
As can be seen by referring to Table 1-3, the capital provided by the equity holders is Total Shareholders' Equity plus the interest-bearing capital provided by debt holders (Short-Term Debt15 and Long-Term Debt):
[1-31]16CE = Total Shareholders' Equity + Short-Term Debt + Long-Term Debt
or
[1-32]CE = TSHE + STD + LTD
or
[1-33]CE = TSHE + IBD
where:
TSHE = Total Shareholders' Equity, STD = Short-Term Debt, LTD = Long-Term Debt, and IBD = STD + LTD or Interest Bearing Debt
It is worthwhile to note that Accounts Payable and Taxes Payable (and other similar accounts) are also debt. They are excluded from Capital Employed because normally they are not interest bearing.
Example 1-3: Calculating ROCE
The Income Statement (Table 1-1) states the EBIT for year n is $11,500,000. The Balance Sheet (Table 1-3) shows that Total Shareholders' Equity is $34,500,000 and that the company is debt free.
Substituting in Equation [1-32] the Capital Employed is calculated to be
[1-32]CE = TSHE + STD + LTD
CE = 34,500,000 + 0 + 0 = $34,500,000
Substituting for EBIT, Tax Rate (TR), and CE in Equation [1-30],
[1-30]
Drivers of Return on Capital Employed
If ROCE is to be used as a measurement of performance, then it seems logical that management would want to understand what drives ROCE. A more insightful understanding of the drivers of ROCE can be obtained by examining the relationships between ROCE and the Income Statement accounts.
Recall that Equation [1-30] defined ROCE as
[1-30]
To introduce EBITDA it's necessary to recall Equation [1-5], which defined EBIT as
[1-5]EBIT = EBITDA – D & A
Substituting for EBIT in Equation [1-30] gives an expression for ROCE in terms of Income Statement variables and Capital Employed.
[1-34]18
Since
[1-32]CE = TSHE + STD + LTD
Accrued Liabilities are assumed to be included in Accounts Payable to simplify the discussion.
Capital Employed can also be defined as: CE = Total Assets – Current Liabilities + Short-Term Debt.
An ROCE of this magnitude produced on a consistent basis would be attractive to many investors.
The reader can check the result of Equation [1-34] by entering the appropriate values for EBITDA, D&A, NetInt, TR, and CE from Tables 1-1 and 1-3.
