The God Ratio in Finance

Published in The Hindu - Sunday Magazine on Apr 12, 2009

If there were one metric to measure a company’s performance that would be its return-on-capital.

In my previous article I had discussed about the Buffett philosophy of investing in high return-on-capital companies and how a high return-on-capital is a reflection of a company’s superior business model (assuming the company’s reported numbers are correct!). Here’s how to calculate the ratio and use it as a metric for choosing companies to invest-in for the long-term.

In simple terms the return-on-capital is the amount that the company generates in a year expressed as a % of the total capital that it uses. In practice, companies use a combination of equity capital and debt capital. Equity capital is the money contributed by promoters and other shareholders in return for shares in the company plus the portion of past profits that are retained in the company over the years. Since shareholders are the owners of a company, the company’s retained profits belong to shareholders and are considered part of equity capital. (Beginners, please note that companies typically retain a portion of the profits that they earn every year (for expansion) while distributing the remaining through dividends etc.).

Debt capital is the money borrowed from the bank or from other investors by issuing them bonds that carries interest charges. The ‘Total capital’ in a company is the sum of ‘Equity capital’ and ‘Debt capital’. This value can be got from the Balance Sheet of a company under ‘Source of Funds’. The ‘Source of Funds’ is split between ‘Shareholders funds’ (i.e. Equity Capital) and ‘Loan funds’ (i.e. Debt Capital).

The calculation

Return on capital (or Return on Total capital) for a company in a particular year (in %) = (Net Profit + Interest Charges) for the year *100/ (Equity capital + Debt capital) at end of previous year

For a company with zero debt, the Return on Total capital becomes equal to Return on Equity capital (in %) =
Net Profit for the year *100 / Equity capital at end of previous year

Now that you got the ‘Source of funds’ value (i.e. Total capital that the company possesses for doing business), you know what goes into the denominator of the Return-on-capital formula. Next is the numerator, which is the amount that the company generates on the total capital that it owns. The numerator, just like the denominator consists of two parts – one part is the amount that the company generates on the equity capital and the other the amount that the company pays on debt capital. The former is nothing but what we commonly see reported as the ‘Net Profit’ (otherwise known as Profit after tax) of the company. The latter is the ‘Interest charges’, which is the interest amount that the company pays to those who have lent money to the firm. The Net Profit and Total interest charges during any particular year can again be looked up from the company’s annual report, but this time not in the Balance Sheet but in the Profit & Loss (P&L) Statement.

Debt can distort true picture of company’s profitability

If you have really understood whatever I have explained so far, you must have a nagging question that must have popped up. As shareholders (who contribute to Equity capital) why should we be bothered about ‘Debt capital’ and ‘Interest charges’? Should we just not calculate Return on ‘Equity capital’ i.e. Net Profit/ Equity capital? The answer to this is that we want to know how effectively and efficiently the company is utilizing its ‘Total’ capital, so that we can decide if it is a good business or a poor business. In a way we are saying there is no color of money, when evaluating how well the company is using its money. Some companies borrow a lot of money (in financial parlance – they use “leverage”) in order to increase Return on Equity capital. But this is cheating, because all they are doing is changing the capital structure, which in no way impacts the intrinsic profitability of the business.

To understand this better, let me give you an example - say you buy a property for Rs 1 cr using your savings. After a year your property has appreciated and is worth Rs 1.2 cr. Your return on capital is 20% p.a. (no mean feat). Now imagine your friend also bought a property at the same time you did. But he did something different, along with Rs 1 cr of his equity, he borrowed Rs 4 cr from the bank at 10% p.a. interest rate and bought a property worth Rs 5 cr. At the end of the first year his property is worth Rs 5.75 cr and he decides to sell his property. After repaying his 4 cr loan with interest of Rs 40 lks, he pockets a cool Rs 35 lks. i.e. a return on ‘equity capital’ of 35%. Whose property performed better? Just looking at returns on ‘equity capital’ would give an impression that your friend’s property performed better. But look closer and you will find that the Return on ‘Total capital’ that it generated was Rs 75 lks(35 lks + 40 lks)/ 5 cr = 15%, which incidentally is poorer than the 20% that your own property generated! Your friend’s additional returns did not come from superior property selection but high leverage (or use of debt). You may ask - so what if he used leverage? He still generated better returns on his money (his equity). Yes, but he also assumed a lot of risk. What if his property did not appreciate at all, then he would have recorded a loss for the year due to the interest charges.

Incase you have drifted…this is not an article about real estate investment strategies. What I mean to say is that- for identifying superior businesses (or companies) you need to look at Return on ‘Total capital’ and not just Return on ‘equity capital’, because the latter does not clearly reflect the actual performance of the business. Why? Because, by using a lot of borrowed money one can easily boost the Return on ‘equity capital’. Good businesses do well by generating high return on ‘total’ capital – meaning they don’t have to depend on capital structure for oomph (just like how your property did in the above example).