EVA: Calculating Invested Capital
Calculating invested capital is an important step in finding economic profit because a key idea underlying this metric is charging the company for its use of capital. In order for the company to generate a positive economic profit, it must cover the cost of using the invested capital.
There is more than one way to get to invested capital, but here we use the following three-step method:
- Get invested book capital from the balance sheet.
- Make adjustments that convert accounting accruals to cash.
- Make adjustments that recognize off-balance-sheet sources of funds.
Step 1 - Pulling Invested Book Capital from the Balance Sheet
Let's start by reviewing the balance sheet. Its basic structure says that total assets are equal to the sum of liabilities, plus stockholders' equity:
The first problem with pulling a number directly from the balance sheet is that the balance sheet includes items that are not funding sources. And, for purposes of economic profit, we want to include only the company's funds or financing provided by shareholders and lenders. Consider, for instance, short-term debt, which is a current liability. The company borrowed funds, so this does count as a funding source, and as a part of invested capital. But compare this to accounts payable. These are bills or invoices that are owed to the company's suppliers; the suppliers are not really lending funds or investing in the company. As such, accounts payable is not really part of invested capital.
In the chart below, we highlight in green those accounts on the balance sheet that are part of invested capital. You can think of them as coming from sources that expect a return on this capital:
One way to calculate invested capital is to add up the green-highlighted liabilities on the right-hand side of the balance sheet. However, it turns out in most cases that the items we want to exclude from invested capital are typically listed in current liabilities. These items we want to exclude are called non-interest-bearing current liabilities (NIBCLS). So a quicker way to calculate invested capital is to start with the left-hand side (the assets) and simply subtract the items on the right that are not part of invested capital. In Figure 2, they include customer advances, accounts payable and accrued liabilities. Because the left-hand side equals the right-hand side, starting with the left-hand side will get us to the same result as adding up all the green-highlighted items.
If you look at Figure 3 below, you will see how this equivalency works. We start with total assets on the left-hand side and subtract the NIBCLS. By this process of elimination, we get to invested book capital:
If you are wondering why we don't subtract 'taxes payable', then you are well on your way toward understanding invested capital! You absolutely could exclude taxes payable since the government doesn't really mean to loan or invest in the company. Actually, including taxes payable is a judgment call. Many analysts let this item remain as a source of invested capital (as we did here) because most companies never pay these deferred taxes. These taxes are perpetually deferred, and for this reason, some call them "quasi equity". If the company were going to pay these taxes, we would exclude taxes payable from invested capital, but since the company - in practice - is going to hold onto the extra cash, we are going to charge them for the use of it.
Now let's perform this calculation on Disney. Below in Figure 4 we show the result of subtracting the non-interest-bearing current liabilities from total assets:
Figure 4 (numbers are in millions)
Importance of Consistency Between NOPAT and Invested Capital
Notice that, among the liabilities, a minority interest account of $798 million is included in our invested capital number (i.e. we did not exclude it). This minority interest represents partial interests in Disney subsidiaries held by other companies. For example, Disney may own 90% of a subsidiary, while another company owns the other 10%. When the balance sheets are consolidated (or "rolled up"), all of the assets are included in Disney's balance sheet, even though 10% of this subsidiary's assets belong to another company. A minority interest account equal to this other company's ownership in the subsidiary is therefore created; this minority interest effectively reduces Disney's equity account accordingly.
So why did we include this equity account in invested capital? The reason is the first economic profit principle discussed in chapter 3: the most important thing is consistency between net operating profit after taxes (NOPAT) and invested capital. The return number (NOPAT) must be consistent with the base number (invested capital). And when we calculated NOPAT, we started with EBIT, which is before (or "above") the minority interest deduction on the income statement - in other words, our NOPAT number is not reduced by the minority interest. So to be consistent, we do not reduce our invested capital by the minority interest.
It would be acceptable, although less common, to subtract minority interest from NOPAT and exclude it also from the invested capital calculation. The important thing to keep in mind is the consistency principle, which can solve many of your dilemmas concerning economic profit adjustments: ask if you included or excluded the account from the NOPAT number and treat the adjustment similarly when working with the balance sheet.
Steps 2 and 3 - Making the Cash and Balance Sheet Adjustments
Now that we have calculated invested capital, we have only to make the other two types of adjustments: cash flow adjustments and off-balance-sheet adjustments. Here again, we are guided by our previous decisions in regard to NOPAT. As a reminder, Figure 5 shows the adjustments we already made in chapter 3:
Figure 5 (numbers are in millions)
We are going to match these adjustments on the balance sheet. First, in regard to converting accrual to cash, our goal is simply to adjust the balance sheet to get closer to cash. Second, in performing the important step of capitalizing debt/equity equivalents, our goal is to capture investments or debt obligations that - for whatever reason - are not currently on the balance sheet.
Disney has many operating leases that are economically equivalent to long-term capital leases and therefore represent a debt obligation (note we already did the calculation in chapter 3, where we estimated the present value of these lease obligations at $11,866 million). In the worksheet below in Figure 6, we perform the cash flow adjustments and off-balance-sheet adjustments:
Figure 6 (numbers are in millions)
1. Only applies if company uses LIFO inventory accounting
2. This is an important idea: if the firm expensed R&D, we want to capitalize it as an asset. This simply treats the money spent as if it were spent on a long-term asset like a manufacturing plant.
See how our adjustments to invested capital matched our adjustments to get to NOPAT. In both cases, we adjusted for the allowance for bad debt - because it is a paper reserve that does not reflect cash received. In both cases, we treated operating leases like capital leases by adding back the interest component and putting the obligation back onto the balance sheet.
Our worksheet above shows two 'N/As' because, although they do not apply in Disney's case, they are often significant in the economic profit calculation. First, if Disney had a LIFO reserve, we would add that to the invested capital base. Second, if research and development were expensed, we would capitalize it, that is, add it to the balance sheet and thereby treat it as an asset with a long-term payoff. In the next chapter, we itemize a full set of generic adjustments for all situations.
So, for making Disney's cash and balance sheet adjustments, only two additions are needed to arrive at an invested capital base of $58,950 million. This number represents a reasonable estimate of the assets that are funded by debt and equity sources.
Invested capital, which we calculated here, reflects an estimate of the total funds held on behalf of shareholders, lenders and any other financing sources. A key idea in economic profit is that, in the calculation, a company is charged "rent" for the use of these funds. Economic profit then represents all profit in excess of this rental charge.
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