Can a negative Return on Invested Capital (ROIC) be a good thing?

2012-07-09 07:38 -  , Value Investing

Can a negative ROIC be a good thing?

Can a negative Return in Invested Capital (ROIC) be a good thing? This question is asked on NeatValue.com, an Indian Value-Blog. Here is the article.

The Return on Invested Capital (ROIC) is calculated as follows: EBIT / Invested Capital. The Invested Capital consists of property, plant & equipment, the necessary operating working capital, less than interest-free liabilities. Or one could also say, it is equity + finance debt reduced by cash and other assets, not needed for the core business.

Can a negatice ROIC be a good thing? My answer

When the ROIC is the ratio of EBIT and Invested Capital, one of the following conditions must be fulfilled:

1. The EBIT is negative and the Invested Capital positive, or
2. The EBIT is positive and the Invested Capital negative

Can one of this two possibilities be a good thing?

Let’s begin with the negative EBIT

A negative EBIT is by no means a positive thing. Sure, one may argue, that an EBIT might be influenced by one-time charges. So a negative EBIT could be in reality a positive EBIT. But that are accounting issues. It is your choice, whether you should use the given EBIT in the annual report or if you should calculate your own number, that may reflect the economic reality more realistic.
Another way, a negative EBIT could be a positive thing, is, when a company invests in its future and has therefore high costs for a period of time (i.e. for advertising, building new factories that produce losses in the beginning…). If made wisely, those investments will lead to losses today, but to higher EBITs in the future. But if one takes a closer look, that are accounting issues, too. If you invest something, you have the choice to activate the costs on the balance sheet. That may not be allowed with the accounting principles a company must follow, but also here you are free to form your own, more realistic view, of the economic reality of your company if needed.

So a first conclusion: there is not much, that leads to viewing a negative EBIT as a positive thing. A negative ROIC, produced by a negative EBIT and a positive Invested Capital therefore, is not positive.

The negative Invested Capital

A positive EBIT and a negative Invested Capital results in a negative ROIC. If a negative EBIT is bad, a positive EBIT should be a good thing. That’s commom sense. But how should one view a negative Invested Capital? What does that mean, is that positive or negative?

A negative Invested Capital means, there is less than no capital invested. That means, all fixed assets + working capital, less all interest-free liabilities is a negative number. Is that good or bad? It depends… Such a company is a really bad thing, if it will be liquidated. If there are more interest-free liabilities than assets, nothing remains for either shareholders or bondholders.

But if such a company remains in business, a negative invested capital may be a really outstanding thing. That means, if growing the company in its core business, you have to invest no money. On the contrary, you will be paid for that. Your interest-free liabilities grow faster than your assets. If nothing changes, you can use this extra money for whatever you want indefinitely. A negative ROIC of that kind is not bad, it is even better than having an infinite ROIC.

Conclusion

A business with a negative ROIC, arising from a negative Invested Capital can be a dream business. You get paid, if you grow. So as long as the business does not shrink, a negative ROIC can be one of the best things an investor can dream of.


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