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The first thing to note about the Balance Sheet shown in Table 1-3 is by definition:

[1-19]Total Assets = Total Liabilities + Total Shareholders' Equity (TSHE)

or

[1-20]Total Assets = Total Liabilities + TSHE

Table 1-3 Basic Balance Sheet

If Equation [1-19] isn't satisfied, the Balance Sheet isn't balanced and there is something wrong with the numbers.

Following the model used when analyzing the Basic Income Statement, an inspection of the Balance Sheet in Table 1-3 results in a number of equations that describe the relationships between the various accounts.

[1-21]Total Assets = Total Current Liabilities + Net Fixed Assets

+ Net Intangible Assets

Current Assets consists of Cash, Accounts Receivable (money customers owe the company), and Inventory. Therefore:

[1-22]Current Assets = Cash + Accounts Receivable + Inventory

Similarly, Fixed Assets consists of Property, Plant, and Equipment (PP&E), which represent the fixed assets the Company needs to produce its deliverable, and Accumulated Depreciation, which represents how much of these assets have been expensed through the Income Statement as they wear out.

For example, if a hard asset is purchased for $5,000,000 and has an estimated useful life of 10 years, then the amount the asset would be depreciated each year would be $500,000 ($5,000,000/10)12 and after two years the accumulated depreciation for this asset would be $1,000,000 ($500,000 * 2).

All of this can be expressed as

[1-23]Net Fixed Assets = PP&E at Cost – Accumulated Depreciation

Intangible Assets includes such things as Goodwill, which is created when an Asset is purchased at a price in excess of its book value. Other Intangible Assets are such things as patents, non-competes, and customer lists if acquired as part of an M&A transaction.13

Again an example may be helpful. If a patent acquired as part of an acquisition of a company was valued at $3,000,000 and had 10 years remaining before expiring, it would be amortized at a rate of $300,000 ($3,000,000/10) per year for 10 years and at such time the accumulated amortization associated with the patent would be $3,000,000, leaving a net tangible value for this asset of zero.

Net Intangible Assets can be defined by Equation [1-24]:

[1-24]Net Intangible Assets = Goodwill & 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]

17 17

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

then

[1-35]

Equation [1-34] defines the impact EBITDA, Depreciation and Amortization, Taxes, and Capital Employed have on the Return on Capital Employed. Managers have the ability to impact all of these variables. As mentioned earlier, tax minimization is best handled by getting good advice. Depreciation and Amortization is the price paid for making investments to drive Revenue, EBIT, and ultimately Net Income. The amount of Capital Employed is a consequence of the capital structure (combination of debt and equity) and how well management manages the company's balance sheet. Equation [1-35] clearly spells out how important it is for management to do its homework up front, select the best investment opportunities, and aggressively manage them and the balance sheet if they are to deliver returns in line with expectations.

Now that the groundwork for understanding the drivers of the Return on Capital Employed has been laid, it's appropriate to turn attention to cash flow and what drives it. However, before that is done another kind of capital needs to be discussed.

Working Capital

Working Capital (WC) is defined as

[1-36]WC = Current Assets − Current Liabilities

It is the Capital that the Company works with on a daily basis to produce its deliverable, collect money, and pay its bills. Equation [1-22] defines Current Assets as consisting of Cash, Accounts Receivable (AR), and Inventory (Inv):

[1-22]Current Assets = Cash + Accounts Receivable + Inventory

or

[1-37]CA = Cash + AR + Inv

Similarly, Equation [1-26] defines Current Liabilities as consisting of Accounts Payable (AP), Taxes Payable (TP), and Short-Term Debt (STD):

[1-26]Current Liabilities = Accounts Payable + Taxes Payable

+ Short-Term Debt

or

[1-38]CL = AP + TP + STD

Substituting Equations [1-37] and [1-38] in Equation [1-36] creates an expression for WC in terms of its Balance Sheet accounts.

[1-39]WC = (Cash + AR + Inv) − (AP + TP + STD)

Example 1-4: Calculating the Working Capital for a Company

The Working Capital for the Company represented by the Balance Sheet shown in Table 1-3 can be calculated by using Equation [1-39].

Substituting the values for Cash, Accounts Receivable, Inventory, Accounts Payable, Taxes Payable, and Short-Term Debt into Equation [1-39] gives a value of $9,500,000 for Working Capital.

[1-39]WC = (Cash + AR + Inv) − (AP + TP + STD)

WC = (750,000 + 6,250,000 + 5,000,000) − (2,500,000 + 0 + 0)

WC = 12,000,000 − 2,500,000 = $9,500,000

As can be seen from this, calculating the Working Capital employed in a company is a straightforward exercise. However, when it comes to the Cash Flow Statement, dealing with Working Capital is a little more complicated.19 This will be illustrated in the following example.

Example 1-5: Calculating the Change in Working Capital

Table 1-4 shows the Working Capital accounts for the company represented by the Balance Sheet shown in Table 1-3 for the Current and Prior Years.

Table 1-4 Calculating the Change in Working Capital

The first thing that one should notice is that “Cash” is missing. The reason for this is when it comes to the Cash Flow Statement the “Change in Cash” is what the statement determines, so there is no need to be concerned about it here. More on how this works later.

When considering the impact that Working Capital has on the Cash Flow Statement, it's the change (Δ) in the various accounts that is important. The usual procedure used to determine the impact of any change in the “Asset” Working Capital accounts is to subtract the “Current Year” from the “Prior Year” to get the correct sign. When this definition is applied to the Accounts Receivable, Equation [1-40] is obtained.

[1-40]ΔAR = AR₍PriorYear₎ − AR₍CurrentYear₎

Substituting

ΔAR = 5,550,000 − 6,250,000 = − $700,000

Accounts Receivable increased by $700,000. This is $700,000 of Revenues the Company didn't collect during the period covered by the financial statements and represents a use of cash and hence the negative sign.20 Similarly,

[1-41]ΔInv = Inventory₍PriorYear₎ − Inventory₍CurrentYear₎

and

ΔInv = 4,350,000 − 5,000,000 = −$650,000

Here the story is the same except this time it's Inventory that increased by $650,000 from the Prior to the Current Year. Cash was used to accumulate the incremental inventory and so this represents another use of cash.

When it comes to changes in the “Liability” Working Capital Accounts the convention is to subtract “Prior Year” from the “Current Year” in order to get the sign correct. The Change in Accounts Payable is calculated with the use of Equation [1-42],

[1-42]ΔAP = AP₍CurrentYear₎ − AP₍PriorYear₎

and

ΔAP = 2,500,000 − 2,400,000 = +$100,000

Accounts Payable increased by $100,000. This happened because the Company didn't pay some vendors. By not paying vendors, the Company saved $100,000 in cash.

There is no change in the Taxes Payable or Short-Term Debt, so they don't have any impact on Cash. If there had been a change, the analysis would be the same as for the other Working Capital Accounts.

When calculating The Cash Generated or Used by Working Capital, there is need for a convention. A use of Cash (in this case Accounts Receivable and Inventory) is preceded by a negative sign and a Source of Cash is preceded by a plus sign. Applying the proper sign to each term the ΔWC is simply the algebraic sum of all of the Δ's as shown in Equation [1-43].

[1-43]ΔWC = ± ΔAR ± ΔInv ± ΔAP

Substituting the calculated values with the appropriate sign in Equation [1-43] gives the Change in Working Capital.

ΔWC = −700,000 − 650,000 + 100,000 = −$1,250,000

This result agrees with the Change in Working Capital shown in the Cash Flow Statement (Table 1-5).

Table 1-5 Basic Cash Flow Statement