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Hi folks,

Here's a bit about how to calculate ROIC. How I do it, at least. One of the interesting bits (to me) is the handling of Goodwill and Intangible Assets. I posted this a while back on some of the premium boards, but thought it might also be useful here. Starbucks is the example company.

Identifying the components:
Unfortunately, the way financial statements are arranged makes it difficult to calculate ROIC. It's necessary to reorganize the statements to focus on economic profit, eliminating the effects of accounting choices and non-operational issues.

`ROIC = NOPLAT / Invested Capital`

Uh oh, how do I calculate NOPLAT? Where is Invested Capital reported?

Invested Capital:
IC can be calculated two ways, and they can be used to reconcile each other as a self-check.

Method 1:

`Debt + Equity = Total Funds Invested - Non-operating assets = Invested Capital`

Since our focus is operational analysis, to be consistent with NOPLAT we need to deduct non-operational assets. Like excess cash and investments, or properties held for sale, for instance.

Debt consists of all long-term and short-term debt, revolving credit facility, notes payable, etc. Also, I've included capitalized operating leases as a debt equivalent. This is very important for companies that lease a lot of facilities, like restaurants. Unfortunately it's a bit difficult to calculate, and showing that work is outside the scope of this post. A topic for another day...

Equity consists of the following:
`  Net common stock and paid-in capital+ Retained earnings+ Accumulated other comprehensive income (loss)- Treasury stock`

See http://en.wikipedia.org/wiki/Treasury_stock#Accoun... for more on treasury stock accounting.

So at this point, IC consists of all debt, the borrowing of which provided cash to the company to invest in operations. And the cash received from new equity shares when originally sold, as well as any other paid-in capital (see treasury accounting above for possibilities here), plus accumulated Net income, which is moved from the Income Statement to Retained earnings on the B/S. And finally, deducting any equity that was bought back (treasury shares), reducing total capital used in the business.

Finally, we need to consider some equity equivalents: goodwill and other intangible assets, and deferred tax liability.

Goodwill:
Goodwill is the premium paid by an acquiring company over and above the acquired company's tangible book value. US accounting rules changed in 2001. While various "other intangibles" are still amortized, goodwill is not. Instead it is periodically reviewed, and if it is determined to be impaired (declined in value), that amount is written down. Think of it as on-demand lumpy amortization. The idea behind this change is that goodwill potentially has an indefinite useful life.

The equity equivalent here isn't goodwill itself. Goodwill is listed on the balance sheet as an asset. But what happens when intangibles are amortized or when goodwill is written down? It shows up as a non-cash charge against operating income (reduce goodwill asset, reduce operating income). For consistency it makes more sense to have the opposite effect: don't ding income, and don't reduce the original invested capital (at some point overpaying for that acquisition seemed like a good idea...).

So, we add as an equity equivalent the accumulated intangible amortization and goodwill impairments.

Deferred taxes:
The final equity equivalent to consider is deferred taxes. Companies maintain two sets of books. One for reporting, and one for taxation. For reporting purposes, most companies use straight-line depreciation to determine taxes owed, but in their tax books, in real life as it were, they use accelerated depreciation, causing the taxes actually paid to be lower than those reported. The difference is booked as a liability, as the delay in paying the tax is temporary. For growing companies, financial statements will continually overstate the company's actual tax burden. Because of this, it makes sense to consider using Cash Taxes (the tax actually paid) to compute NOPLAT. Using cash taxes eliminates the need to account for deferred taxes. Instead, the difference is net income, which like all net income, is moved to Retained Earnings on the balance sheet. Retained earnings is an element of Equity.

So, bringing all these pieces together, let's use Starbucks as an example, using full year-end instead of 2009 mid year ttm, as it may be easier to follow along.
`                                             2008       2007  Excess cash                               114.6      250.5+ Long-term investments                      71.4       21.0------------------------------------------------------------  Non-operating assets                      186.0      271.5  Deferred tax liability                        0          0- Deferred tax assets                       234.2      129.5------------------------------------------------------------  Net deferred tax liability               -234.2     -129.5  Short-term debt                           713.7      711.0+ Long-term debt                            549.6      550.1+ Capitalized operating leases             3994.0     3908.0------------------------------------------------------------  Total debt and equivalents               5257.3     5169.1  Net common stock and paid-in capital       40.1       40.1+ Retained earnings                        2402.4     2189.4+ Accumulated other comp. income (loss)      48.4       54.6- Treasury stock                              0.0        0.0+ Cumulative goodwill impairments             0.0        0.0+ Cumulative intangibles amortization         5.9        4.3+ Net deferred tax liability               -234.2     -129.5------------------------------------------------------------  Total equity and equivalents             2262.6     2158.9------------------------------------------------------------  Total Funds Invested                     7519.9     7328.1- Non-operating assets                      186.0      271.5------------------------------------------------------------  Invested Capital                         7333.9     7056.6`

Finally, let's come at IC from the other direction, reconciling the above calculations.

You'll notice (below) I've included Equity Investments (listed as a long-term asset on the b/s) in operating invested capital. This is a judgement call. "Equity method" accounting represents Starbucks' 20-50% ownership of other companies. In many cases these might be considered non-operating assets, as we don't have a control position. But in Starbucks' case, these are mostly all 50% partnerships with other companies that run .... you guessed it .... Starbucks coffee shops. At least I think that's the case from reading the 10-K. So, I've deemed these to be operating assets.

Method 2:
`Operating Assets - Operating Liabs = IC + Non-operating Assets = Total Funds Invested                                             2008       2007  Working cash                              207.7      188.2+ Receivables                               329.5      287.9+ Inventories                               692.8      691.7+ Other current assets                      169.2      148.8------------------------------------------------------------  Operating current assets                 1399.2     1316.5  Accounts payable                          324.9      390.8+ Accrued expenses                          630.2      756.8+ Insurance reserves                        152.5        0.0+ Deferred revenue                          368.4      296.9------------------------------------------------------------  Operating current liabilities            1476.0     1444.5------------------------------------------------------------  Operating working capital                 -76.8     -128.0  Operating working capital                 -76.8     -128.0+ Net property and equipment               2956.4     2890.4+ Capitalized operating leases             3994.0     3908.0+ Other assets                              261.1      219.4+ Equity investments                        302.6      258.8- Other liabilities                         442.4      354.1------------------------------------------------------------  Invested Capital (excl goodwill)         6994.9     6794.6+ Goodwill                                  266.5      215.6+ Intangibles                                66.6       42.0+ Cumulative goodwill impairments             0.0        0.0+ Cumulative intangibles amortization         5.9        4.3------------------------------------------------------------  Invested Capital (incl goodwill)         7333.9     7056.6+ Non-operating assets                      186.0      271.5------------------------------------------------------------  Total funds invested                     7519.9     7328.1`

Whew! So, now we have a fairly rigorous breakdown of invested capital. The next post in this series will show the details of NOPLAT, and put it all together to get ROIC.