Two Comments on the Calculation of ROA
First, some analysts subtract average non-interest-bearing liabilities (such as accounts payable and accrued liabilities) from average total assets in the denominator of ROA, the argument being that these items are sources of indirect financing. An alternative argument for reducing total assets by non-interest-bearing liabilities is that ROA is better characterized as a return on invested capital when items that are not directly invested capital (such as accounts payable) are purged from total assets
Economics suggests that when liabilities do not provide for explicit interest charges, the creditor charges implicit interest by adjusting the terms of the contract, such as offering discounts for those who do pay immediately or setting higher prices for those who do not pay immediately. The numerator of the ROA calculation is a measure of income before deducting financing costs; therefore, an alternative approach would be to use total assets in the denominator (i.e., do not subtract non-interest-bearing liabilities) but adjust net income for both explicit and implicit financing costs. Unfortunately, it is quite difficult to reliably estimate the implicit interest charges associated with noninterest- bearing liabilities such as accounts payable and accrued liabilities and to reclassify the implicit increments for financing charges in cost of goods sold and selling, general, and administrative expenses to interest expense (which is added back to net income).
Adjusting prefinancing income this way would increase the measure of operating income in the numerator, increasing calculated ROA. (The alternative of reducing the denominator by subtracting non-interest-bearing liabilities from total assets also would increase calculated ROA.) Despite the reasonable arguments for adjusting income in the ROA calculation to account for implicit interest or adjusting total assets for indirectly invested capital, in all but extreme cases such adjustments generally result in only minor changes in time-series or cross-sectional analyses of ROA. Combined with the low degree of precision in estimating such amounts, the examples and problems in this book follow the conventional practice of using average total assets in the denominator of ROA, making no adjustment for non-interest-bearing liabilities
Second, it is important to note that although we adjusted the numerator of ROA for unusual or nonrecurring items, we did not adjust the denominator. This implicitly assumes the unusual or nonrecurring items are not persistent but that their effects on total assets are persistent. For example, consider the restructuring charges that were added back to net income. These impairment charges probably reduced the carrying value of some assets. Our adjustment added back to net income the effect of the charges on the income statement but did not add back the effects of the restructuring charges in the ending balance of total assets, which will be lower because of the write-down. Thus, our adjustment to the numerator (an increase) was coupled with the impact of the unadjusted balance sheet effects in the denominator (a decrease), leading to an upward bias in our calculation of adjusted ROA. The logic behind this seemingly inconsistent treatment is motivated by a desire to compute sustainable ROA.
The current period restructuring charges should not persist in future periods, but the asset write-downs are permanent (some assets are now worth less or may have been written off entirely); thus, the adjusted ROA provides a better indicator of the ROA we might expect to observe next period even though it is a biased measured of the current period’s ROA. Again, our approach reflects conventional practice, but the astute analyst should understand that blindly ignoring negative charges on the income statement but allowing them to affect the balance sheet can affect calculations of adjusted performance.
First, some analysts subtract average non-interest-bearing liabilities (such as accounts payable and accrued liabilities) from average total assets in the denominator of ROA, the argument being that these items are sources of indirect financing. An alternative argument for reducing total assets by non-interest-bearing liabilities is that ROA is better characterized as a return on invested capital when items that are not directly invested capital (such as accounts payable) are purged from total assets
Economics suggests that when liabilities do not provide for explicit interest charges, the creditor charges implicit interest by adjusting the terms of the contract, such as offering discounts for those who do pay immediately or setting higher prices for those who do not pay immediately. The numerator of the ROA calculation is a measure of income before deducting financing costs; therefore, an alternative approach would be to use total assets in the denominator (i.e., do not subtract non-interest-bearing liabilities) but adjust net income for both explicit and implicit financing costs. Unfortunately, it is quite difficult to reliably estimate the implicit interest charges associated with noninterest- bearing liabilities such as accounts payable and accrued liabilities and to reclassify the implicit increments for financing charges in cost of goods sold and selling, general, and administrative expenses to interest expense (which is added back to net income).
Adjusting prefinancing income this way would increase the measure of operating income in the numerator, increasing calculated ROA. (The alternative of reducing the denominator by subtracting non-interest-bearing liabilities from total assets also would increase calculated ROA.) Despite the reasonable arguments for adjusting income in the ROA calculation to account for implicit interest or adjusting total assets for indirectly invested capital, in all but extreme cases such adjustments generally result in only minor changes in time-series or cross-sectional analyses of ROA. Combined with the low degree of precision in estimating such amounts, the examples and problems in this book follow the conventional practice of using average total assets in the denominator of ROA, making no adjustment for non-interest-bearing liabilities
Second, it is important to note that although we adjusted the numerator of ROA for unusual or nonrecurring items, we did not adjust the denominator. This implicitly assumes the unusual or nonrecurring items are not persistent but that their effects on total assets are persistent. For example, consider the restructuring charges that were added back to net income. These impairment charges probably reduced the carrying value of some assets. Our adjustment added back to net income the effect of the charges on the income statement but did not add back the effects of the restructuring charges in the ending balance of total assets, which will be lower because of the write-down. Thus, our adjustment to the numerator (an increase) was coupled with the impact of the unadjusted balance sheet effects in the denominator (a decrease), leading to an upward bias in our calculation of adjusted ROA. The logic behind this seemingly inconsistent treatment is motivated by a desire to compute sustainable ROA.
The current period restructuring charges should not persist in future periods, but the asset write-downs are permanent (some assets are now worth less or may have been written off entirely); thus, the adjusted ROA provides a better indicator of the ROA we might expect to observe next period even though it is a biased measured of the current period’s ROA. Again, our approach reflects conventional practice, but the astute analyst should understand that blindly ignoring negative charges on the income statement but allowing them to affect the balance sheet can affect calculations of adjusted performance.
No comments:
Post a Comment