Karlson Lawrence C.

Corporate Value Creation


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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 = EBITDAD & 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 AssetsCurrent 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.