Adjusted economic roa

Adjusted Economic ROA

Adjusted Economic Return on Assets (Adjusted Economic ROA) is a sophisticated financial metric that refines the traditional Return on Assets (ROA) by incorporating economic costs, particularly the opportunity cost of capital. This approach aims to provide a more accurate picture of a company's true profitability and efficiency in utilizing its total assets within the broader category of financial performance metrics. Unlike standard accounting measures, Adjusted Economic ROA accounts for both explicit costs and implicit costs, offering deeper insights into value creation.

History and Origin

The concept of economic profit, which underpins Adjusted Economic ROA, has roots in classical economics, distinguishing itself from accounting profit by including the implicit costs of doing business, such as the minimum return required by investors. While traditional accounting focuses on historical costs and explicit transactions as reported in financial statements, the economic perspective seeks to evaluate the true economic viability of an enterprise.

The evolution of financial reporting standards, particularly in the United States, has been shaped by organizations like the Financial Accounting Standards Board (FASB), established in 1973. The FASB sets Generally Accepted Accounting Principles (GAAP), which govern how companies prepare their financial reports, ensuring consistency and comparability⁵, ⁶. However, traditional GAAP measures, including conventional ROA, often do not explicitly capture the full spectrum of economic costs, leading to the development of adjusted metrics like Adjusted Economic ROA to bridge this gap and provide a more comprehensive view of corporate performance.

Key Takeaways

• Adjusted Economic ROA evaluates a company's profitability by considering both explicit accounting costs and implicit economic costs, including the opportunity cost of capital.
• It provides a more holistic view of how efficiently a company uses its assets to generate returns beyond the minimum required by investors.
• This metric helps in assessing the true economic value created by a business, aiding in strategic decision-making and resource allocation.
• Calculating Adjusted Economic ROA typically involves adjusting reported net income for implicit costs before dividing by total assets.

Formula and Calculation

The calculation of Adjusted Economic ROA begins with a company’s net operating profit after tax (NOPAT), which is then adjusted for the imputed cost of capital. This "charge" for capital represents the opportunity cost of the funds tied up in the business's assets.

The basic formula for Adjusted Economic ROA can be expressed as:

Where:

• NOPAT (Net Operating Profit After Tax): Represents the company's potential cash earnings if its capital structure were entirely equity-financed.
• Invested Capital: The total capital deployed by the company to generate its operating profit, often approximated by total assets less non-interest-bearing current liabilities.
• Weighted Average Cost of Capital (WACC): The average rate of return a company expects to pay to its investors (both debt and equity holders). This is the key component that introduces the concept of opportunity cost.
• Total Assets: The sum of all assets on the company's balance sheet.

This formula highlights how Adjusted Economic ROA moves beyond simple accounting profit by deducting a charge for the capital employed, reflecting the economic return generated per dollar of assets after accounting for the cost of financing those assets.

Interpreting the Adjusted Economic ROA

Interpreting Adjusted Economic ROA involves assessing whether a company is generating returns that exceed its cost of capital on its asset base. A positive Adjusted Economic ROA indicates that the company is creating economic value, meaning its assets are generating a return higher than what investors could earn from an alternative investment of similar risk. Conversely, a negative Adjusted Economic ROA suggests that the company's assets are not generating sufficient returns to cover the cost of the capital invested in them, potentially destroying shareholder value.

This metric is particularly useful for internal management to gauge the efficiency of asset utilization and for external investors to evaluate a company's long-term sustainability and competitive advantage. It helps in understanding whether a company's operations are truly profitable from an economic standpoint, not just an accounting one. Financial analysis often uses this metric to benchmark performance against competitors or industry averages.

Hypothetical Example

Consider "InnovateTech Inc.," a software development company, and "Durable Manufacturing Co.," a heavy machinery manufacturer.

InnovateTech Inc.:

• NOPAT: $1,500,000
• Invested Capital: $10,000,000
• WACC: 10%
• Total Assets: $12,000,000

Calculation:
Economic Charge = $10,000,000 * 10% = $1,000,000
Adjusted Economic ROA = ($1,500,000 - $1,000,000) / $12,000,000 = $500,000 / $12,000,000 = 0.0417 or 4.17%

Durable Manufacturing Co.:

• NOPAT: $5,000,000
• Invested Capital: $70,000,000
• WACC: 8%
• Total Assets: $80,000,000

Calculation:
Economic Charge = $70,000,000 * 8% = $5,600,000
Adjusted Economic ROA = ($5,000,000 - $5,600,000) / $80,000,000 = -$600,000 / $80,000,000 = -0.0075 or -0.75%

In this example, InnovateTech Inc. has a positive Adjusted Economic ROA of 4.17%, indicating it is creating economic value. Durable Manufacturing Co., despite a higher NOPAT, has a negative Adjusted Economic ROA of -0.75%, suggesting its returns are not covering its cost of capital when considering its substantial invested capital. This highlights how traditional income statement figures alone might be misleading without incorporating the cost of capital.

Practical Applications

Adjusted Economic ROA finds practical applications across various facets of financial decision-making and analysis:

• Investment Analysis: Investors utilize Adjusted Economic ROA to assess the true economic performance of companies, helping them identify businesses that are genuinely creating value beyond their cost of capital. This provides a more robust basis for valuation decisions.
• Capital Budgeting: Companies can use this metric to evaluate potential projects and investments. Projects with an expected positive Adjusted Economic ROA would indicate that they are likely to generate returns above the cost of the capital deployed.
• Performance Evaluation: Management employs Adjusted Economic ROA to gauge the efficiency of different business units or asset classes. It encourages managers to not only increase revenue but also to manage assets and capital effectively.
• Corporate Governance: Boards of directors and corporate governance bodies may incorporate Adjusted Economic ROA into executive compensation structures, aligning management incentives with long-term shareholder wealth creation.
• Regulatory Scrutiny: Regulators, such as the Securities and Exchange Commission (SEC), emphasize the importance of transparent and meaningful disclosures of performance metrics. The SEC's guidance on key performance indicators (KPIs) in Management's Discussion & Analysis (MD&A) encourages companies to provide clear definitions and explanations of how these metrics are used by management, even for non-GAAP measures, to ensure investors can fully understand the business's performance. ³, ⁴This regulatory push indirectly supports the use of comprehensive metrics like Adjusted Economic ROA.

Limitations and Criticisms

While Adjusted Economic ROA offers a more comprehensive view of a company's economic performance, it is not without limitations. A primary criticism stems from the inherent subjectivity in calculating the cost of capital and identifying all implicit costs. Unlike explicit, easily verifiable accounting figures, opportunity costs require estimation, which can introduce variability and potential manipulation.

Furthermore, the effectiveness of Adjusted Economic ROA depends heavily on the accuracy of the underlying accounting data. Adjustments made to reported financial figures to arrive at economic profit measures can be complex and are not standardized across all companies. This lack of standardization can hinder comparability between firms, even within the same industry. Economic profit measures, including those related to ROA, also face challenges when accounting for intangible assets, such as brand value or intellectual property, which are crucial for many modern businesses but are not always fully reflected on a balance sheet under traditional accounting rules. ²Such critiques suggest that while economic profit provides valuable insight, it should be used in conjunction with other financial indicators to form a complete assessment of a firm's performance.

Adjusted Economic ROA vs. Economic Value Added (EVA)

Adjusted Economic ROA and Economic Value Added (EVA) are both profitability metrics that incorporate the cost of capital to measure true economic profit, but they differ in their ultimate output.

• Adjusted Economic ROA expresses the economic profit as a percentage of total assets. It answers the question: "What is the true rate of return generated by the company's assets after accounting for the cost of capital?"
• EVA, typically a dollar-denominated figure, represents the absolute dollar amount of economic profit a company generates above its cost of capital. It answers the question: "How much economic value, in dollars, has the company created for its shareholders?"

The key difference lies in their presentation and emphasis. Adjusted Economic ROA provides a ratio, useful for comparing efficiency across companies of different sizes or over time, relative to their asset base. EVA provides an absolute value, which is particularly useful for understanding the total wealth created or destroyed. Both metrics aim to overcome the limitations of traditional accounting profit by factoring in the cost of capital and implicitly acknowledging opportunity costs, thereby offering a more economically sound assessment of a company's performance.
¹

FAQs

Why is it called "adjusted"?

It's called "adjusted" because it takes the standard accounting measure of Return on Assets (ROA) and adjusts it to include economic costs, most notably the cost of capital, which is not typically reflected in traditional accounting profits. This adjustment aims to provide a more economically complete picture of performance.

How does it differ from traditional ROA?

Traditional Return on Assets (ROA) is calculated using accounting net income, which only deducts explicit costs. Adjusted Economic ROA goes further by also deducting implicit costs, especially the opportunity cost of the capital tied up in the business's assets. This means Adjusted Economic ROA provides a more stringent measure of profitability.

Is Adjusted Economic ROA a GAAP measure?

No, Adjusted Economic ROA is not a Generally Accepted Accounting Principle (GAAP) measure. GAAP provides a framework for financial reporting that focuses on explicit transactions and historical costs. Adjusted Economic ROA is a non-GAAP metric, often used internally by management or by analysts to gain deeper insights into a company's economic performance.

Can a company have positive accounting ROA but negative Adjusted Economic ROA?

Yes, this is possible and highlights the value of the adjusted metric. A company might show a positive accounting Return on Assets (ROA) if its net income is positive. However, if the returns generated by its assets are less than the cost of the capital used to acquire those assets (i.e., its implicit cost of capital is high), its Adjusted Economic ROA could be negative, indicating it's not truly creating economic value.