No Trash Talk Allowed

by Lora Cecere on February 17, 2014 · 1 comment

Definition of Asset

 A resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit.

Definition of Trash

Worthless or discarded material or objects, refuse or rubbish.

In the last year of my Wharton MBA program, the professor wrote on the board that “finance is the art of money passing hands until nothing is left.” I have found this to be a sad reality. In contrast, economic value is derived  from making or growing things to be sold.

In the process of making things, companies have to account for assets. While all leaders can agree that they want more assets and less trash, there is confusion about the best metric.

There are a number of ways that companies can account for assets and align them for value.  Recently, we have been studying the trends on three different measures of asset effectiveness. These three simple definitions have very different implications with far-reaching impacts. It is the goal of this blog post to explain the differences and help link you to the most impactful measurement to drive shareholder value.

  • ROA: The return on assets is equal to net income/total assets. It can vary substantially across industries and should only be used to compare a company within an industry peer group. The assets are based on both debt and equity.
  • RONA: If you ask my friends at DuPont for the best asset measure, they will advocate Return on Net Assets (RONA). It is different from ROA in that it is equal to Net Income/(Fixed Assets + Net Working Capital). Fixed assets are tangible property and working capital is a measurement of current assets minus current liabilities. It is a longer-term perspective than ROA.
  • ROIC: Colgate and other consumer products companies swear by the Return on Invested Capital (ROIC) metric. It is a good measure of the company’s ability to generate a profitable outcome from investments. ROIC should be greater than the market value of capital. It is equal to net income-dividends/total capital. It can also be calculated as (net operating profit after taxation)/(invested capital).
When we correlate these three metrics to market capitalization, ROIC correlates in 85% of the industries, and RONA and ROA in 25% of industries.  Most supply chain leaders measure themselves by ROA. The more work that I do on metrics, the more I become a fan of ROIC.
To prove the point, let’s look closely at the numbers for the food industry. Note how different the numbers are. ROIC is not only a measurement of assets, but also the use of capital. Sadly, several of these companies don’t look bad when you look at ROA, but when you look at ROIC, it is clear that they are operating at a level below the market cost of capital.
For me this is not trash talk. Instead, it is about supply chain leaders delivering value.  If the cost of capital is 18% (a good average), then the top performance would go to Campbells, and many companies should be having the discussion of why they are under performing to market.
And, of course, the supply chain is a complex system with increasing complexity. Asset metrics should not be viewed in isolation to declare a supply chain winner. There are metric dependencies, but I like the inclusion of ROIC in the basket portfolio of metrics. What do you think? What do you think is the best measurement?

{ 1 comment… read it below or add one }

Jonah McIntire March 7, 2014 at 8:40 am

Good article. I think ROIC has its place, but needs to be used with caution when supporting a “which company is better” question. ROIC is a ratio (i.e. a percentage) and as such is scale-independent. In effect, ROIC is a measure of the efficiency of generating residual cash flow relative to the capital a company has invested in its business. Executives (especially public company executives) are not targeting high efficiency, but rather high absolute performance. This is not just an academic difference. For example, consider a dividend-paying company that makes the following move:

Year 1:
Net Profit = 400m
Adjusted Taxes = 25m
Invested Capital = 100m
Shares Outstanding = 10m
ROIC = 375%
Dividend = $37.5

Year 2:
Net Profit = 500m
Adjusted Taxes = 25m
Invested Capital = 130m
Shares Outstanding = 10m
*ROIC = 365%
Dividend = $47.5*

The example shows that ROIC declined while the shareholder value increased. The point is actually pretty simple: its possible to be less efficient with invested capital but still achieve higher absolute return performance.

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