KPI Closeup is a series dedicated to the key metrics CFOs heed to perform in a highly competitive landscape. You can find the entire series here.
For finance professionals who track return on invested capital (ROIC), it is one of the most important KPIs in their toolbox. But for many other finance professionals, the metric is perceived as optional.
Jack McCullough, president of the CFO Leadership Council, thinks there are a few reasons for the difference in opinion — starting with how you define ROIC. Perhaps, finance leaders can't agree on what it means, says McCullough.
"In the simplest terms, [ROIC] is a net operating profit after taxes, divided by invested capital, long-term debt, plus equity — and, some people say, minus cash," McCullough said. "It's similar to ROI, but the nuance is that ROIC includes debt, while ROI is more useful for a particular project."
But how you view the utility of the metric might also depend on where you sit. If you're on the investor side, few metrics can tell you as much about how well the company manages its business. But if you're on the executive side, especially if you're focused on the here-and-now, the perspective it offers might be too long-term.
Investors' favorite KPI
"Investors like it mainly because it's strategic, and it's a long-term investment tool," McCullough said. Finance people who don't track ROIC might instead focus on EBITDA. But this switch poses a problem: in focusing on EBITDA, executives tend to sacrifice the long-term to improve the current quarter's numbers.
"If you're only focused on what's going to happen in the next 90 days, that's understandable, but it's a dumb way to run a company," McCullough said. "ROIC is a vastly superior way to measure long-term success than EBITDA, which is just short term."
ROIC is much more commonly tracked among larger, more established publicly traded companies, Jason Maynard, senior vice president of global field operations at Oracle NetSuite, says. "I don't see smaller companies tracking it that closely; small family-owned businesses especially."
But when it comes to explosive growth and profitability, ROIC becomes increasingly significant.
"ROIC comes into play more at venture-or private equity-backed companies," Maynard said. "But oftentimes, these companies are still in high-growth mode, still trying, in many cases, to invest in the business. They're focused more on optimizing cash flow; when you grow, and have to make more sophisticated decisions, ROIC becomes more useful."
The performance dilemma
One possible reason investors tend to think in ROIC terms more than executives has to do with compensation; executive earnings and bonuses are tied to accounting earnings, for the most part, including EBITDA and net income, said McCullough. "But I'm not aware of a single company in which executive earnings are tied to ROIC, so it's not going to be the focus."
Focusing on ROIC is especially critical in a down market, he says, more so than an up market, because of its nature as a long-term metric. Mistakes can be forgiven in an upmarket that can't be in a down market.
"We happen to be in an up market now," he said. "So, if you're a CFO and you dramatically overpay for something, the market almost doesn't care. But if your company stock isn't growing, you'll get punished for bad acquisitions."
McCullough names one company that has performed well because of its ROIC focus: Domino's Pizza, under the leadership of CEO Jeff Lawrence and his attention to long-term investments.
Domino's online order tracker was revolutionary for its time, preceding the mobile app revolution. But this long-term vision was not prudent in the short term. "Look at their stock since the IPO; it's outperformed Facebook and Apple," McCullough says.
McCullough also names GM, which has recognized that "green" cars are a growth segment and the company has subsequently invested heavily in it. "That's how you improve your ROIC: figure out what's going to work in the future, and invest there, rather than just invest in what's profitable right now," he said.
"It's hard to do, but it's critical,'" he said.
Where ROIC is No. 1
Jason Cherubini, co-founder and acting CFO-COO of Dawn's Light Media, says in the film business, ROIC is a vital KPI, "along with payback period and risk valuation," he says.
"Whenever we put money out, we're looking at recouping that full investment, normally within 18 to 24 months," he said. "We're really not investing in any fixed assets or PP&E we're using in operations. We're investing in creating an asset we're going to sell off."
Cherubini says Dawn's Light's business model is similar to that of real estate, flipping houses — creating with intent of selling off.
Cherubini breaks ROIC into return on equity, which is how much of the company's cash needs go into a project, and return on assets, which is how much total investment, including any debt they might be able to take on for a project.
Tracking ROIC is important across industries, but doesn't necessarily have to do with day to day operations; it has more to do with capital budgeting, Cherubini says. "When the CFO is looking at the 5-year or 10-year investment plans, they're really looking at capital, and where it should be allocated."
Cherubini has also consistently focused on differentiating between expected returns and potential downsides and upsides of returns.
"Often when we're calculating ROIC, we're using estimates of the future, which is expected return, or a forecast," Cherubini said. "But we also want to look at the range. If you told me the options were making zero dollars or $200,000, both with a 50/50 chance, we're flipping the coin.
The expected return is $100,000, which is mathematically correct, but if you end up with zero, the difference is dramatic. "What we focus on is what is that downside potential and really looking at that in our calculations," Cherubini explained. "Not just math calculations, but what's the lowest potential for what we're looking at? No one will complain about making more money."
ROIC integral to company activity
At point-of-sale fintech company LendingUSA, CFO Ron Oertell studies ROIC on a constant basis when looking at the risks associated with the company's assets.
"It absolutely dictates [our decision-making], because, as a consumer finance company, that's what we're doing: investing in assets," Oertell said. "We need to make sure we're only investing in profitable assets; I don't want to invest where I don't have certainty of return. So I need to understand the shape of the loss curve. Am I investing profitably? Or am I losing money on every asset I'm investing?"
When looking at projected ROIC, understanding contingency events that could complicate your assumptions is critical, Oertell added. "I can model out what my return will be over several years, but I need to understand how certain that model is, and perhaps potentially discount my cash flows to take that uncertainty into account."
Darren Heffernan, president of fintech company Trintech, calculates ROIC by dividing profit over invested capital.
"We've got so much opportunity in our market," he said. "We're deciding all the time where we're going to put our capital."
Unlike many KPIs, Heffernan says the significance of ROIC ebbs and flows with the broader economy. "In the current climate, it's not top of mind," he said. "We're more concerned with cash flow and operation efficiencies than returning capital deployment."
A forward-looking KPI
Simultaneously, tracking ROIC gives Heffernan the opportunity to study the broader market and assess where Trintech will be in 18 months, and then ask what he would wish he'd done today.
"We're asking ourselves that all the time: what will we wish we had invested in?" he said. "That's why ROIC is so important for us."
Heffernan encourages CFOs to give their ROIC calculations extra thought, and, if they have any major investment plans, to do them this year.
"We're already in turbulent times," he said. "If you really believe in your business [and] think you've got good long-term prospects, now's the time to find long-term capital."