Hi, welcome back to Finance for Non-Finance Professionals. What I'd like to talk about in this video is using accounting ratios as a capital budgeting tool. There's lots of different accounting ratios that get used inside the firm. In fact, a lot of times the same accounting ratio gets called different things at different firms. And so I would like to talk about them in a general sense and then we'll drill down to some specifics. What I mean in accounting ratio, I mean you take two accounting pieces of data, maybe something like earnings or net income and divide it by something, B. Maybe that's book equity or debt or sales, and we'll call that maybe a gross profitability margin or an epitome multiple or return on invested capital. We could call it lots of different things, but we're going to take two pieces of accounting data, put one over the other and form a ratio. And our decision is going to be very simply, is that ratio bigger than X, some cutoff? So is the profitability to invested capital, which we might call the return on invested capital, is that bigger than whatever the firm uses as a cutoff, maybe 10%, 20%. And that's our decision rule. Is the accounting ratio above what it needs to be in order to justify doing a project? Okay, so let's walk through sort of a specific example of return on invested capital. Our decision rule's going to be is the return on invested capital bigger than some X? Let's walk through a simple example together of computing a return on invested capital. So we want to compute two things. We want to compute the average accounting profit on the project and we want to compute the average invested capital. So in this project we're investing 450 in order to generate sales of 600, 500, and 400 over the next three years. It costs 300 and 250 and 200 to generate those sales. That's the cash outflow associated with costs of goods sold, selling and administrative expense. And then also, there's a depreciation expense here. Now what is that depreciation expense? That reflects the fact that the book value of the asset declines from 450 to 300. There's depreciation, the asset becomes worth less over time. That machine then depreciates from 350 to 150, so this is what we call straight line depreciation. And then from 150 down to 0. Each of those declines in the value of the asset gets written down as an expense. So that 150 decline comes down here as depreciation expense, comes down here as the depreciation expense. Good, with those three numbers we can compute the accounting profit. 600 minus 300 is 300. 300 minus the 150 depreciation expense gives us an accounting profit of 150. Do the same thing in period two. 500 minus 250 minus 150 gives us an accounting profit of 100. In year three that gives us an accounting profit of 50. Okay, we're getting ready to go now because we've got everything we need to compute the two things that we need for the ratio. How much on average profit was generated by the project? 150, 100 and 50, those are our three accounting profits. We're going to take the average of those. How much capital did it take to generate those profits? 450, 300, 150 and 0, those four numbers. Those four numbers are the amount of invested capital, so on average what was our profit? On average our profit was 150 + 100 + 50 divided by 3. What's that going to be? 150 + 100 is 250 + 50 is 300. 300 divided by 3, 100. Good, what was our invested capital? The IC of our LIC? Let's see, we've got four periods of using the equipment, so four balance sheets. 450 + 300 + 150 + 0 divided by 4. Work that out, that's going to come out to 225. Now we can do our accounting ratio at the return on invested capital. I'm going to take my profit, 100, average profit, and divide by my invested capital, 225, to get me an ROIC of about 44%. Okay, so 44% is my return on invested capital. And now, we think to ourselves is that 44% big enough? And that's the capital budgeting decision. If that 44% is above our cutoff, we do the project. If that 44% is below, we don't do the project. We could think about return on invested capital. We could also instead of using invested capital, we could have used assets. We could have used book equity, gross profits. We could have divided them by sales, net profit and divided by net sales. We could have used the profitability index which is the present value of those cash flows divided by the initial investment, lots of different accounting ratios. These are all basically the same flavor. We're just replacing the denominator with some other accounting metric. Now, there's some good things about these accounting ratios. More money is better than less money, right? So in the numerator, it's good. More profit means better profitability, more cash coming in. In the denominator, less capital to generate that money is better, so the ratio makes good sense. It's reasonable that people use this. It does talk about the cost of capital in terms of how long we're using machinery. But the bad is that again, like payback, it neglects the timing. It neglects the timing and this is important, it includes some accounting distortions. Remember that depreciation expense? That depreciation expense is an accounting distortion, it doesn't reflect real cash. That depreciation expense wasn't the check that got issued to somebody. Accountants call it a non-cash expense, which means it's an expense I didn't pay. So, that's fine, it's good from an accounting standpoint to reflect the real depreciation of an asset, but from a finance standpoint, what I care about is money, money, money. And that depreciation expense doesn't reflect the real cash flow. In week three, we're going to start undoing some of those accounting distortions in order to get back to a measure of real cash generation. And it neglects risk, that 44% cutoff, that 44% on the project example that we did, is that good enough? I don't know. If it puts the whole firm at risk, if it means playing Russian roulette with one bullet in the chamber, maybe 44% isn't that good of return. On the other hand, it's hard to sort of adjust the accounting ratio to reflect risk the way we can with the net present value. So my advice on all these accounting ratios is they're okay in isolation, they're informative. They get used a lot internally, but always put them next to a net present value. If you put them next to a net present value, the arbitrary cutoff sort of goes away because the net present value is sort of our North Star or our benchmark for whether or not this project generates value.
