Case Study: High Non-operating assets can draw down returns of great businesses

Case Study 1: Jubilant Foodworks

Jubilant Foodworks has excellent business model with high Operating efficiencies on operating assets but their model has a draw-down on Return on Equity since the management holds near term investments or marketable securities for faster deployment for expansion and working capital needs. But when we break down Return on Equity (ROE) into Operating and Non-Operating assets turnover, high non-operating assets like marketable securities and negligible debt in the balance sheet will weigh down on their ROE ratio.

So if an analyst goes by ROE ratio for 2016 as just 13% and that presented prima facie, will determine the company generates low returns on equity. But we can understand the details only when we break them down to operating and financing deails. Sometimes Dupont model will not help us get insights to understand this intricate level nuances although Dupont model can call out the impact of Financial leverage in the balance sheet.

Jubilant Foodworks`s 2016 and 2017 balance sheet and P&L statements:

Jubilant bs

Jubilant pl

Breakdown of ROE

ROE = Return on Net Operating Assets (RNOA) + Non-Operating return

Operating Return:

RNOA = NOPAT/ Avg Net Op Assets

= 191/ (1074-475)=31%

Or = NOPM X NOAT = Net Op Profit/ Sales* Sales/Net Op Assets

Non-Operating Return:

The non-operating return is a function of both the relative debt in capital structures and the spread of the return on net operating assets over cost of that debt. Its also a component of Return on Equity (ROE)

To put it in a formula to calculate,

Non-Operating Return = FLEV X Spread

Spread= RNOA-NNEP and FLEV is the leverage calculated as Net Non-Operating debt/Average Equity

Where

RNOA is the Return on Net Operating Assets

NNEP is the Net Non-Operating Expense Percentage or Cost of Non-Operating Debt calculated as Net-Non-operating Expenses (NNE)/Net Non-Operating Obligations (NNO). So NNEP = NNE/NNO

Here NNE is Net Non-operating Expense calculated as NOPAT – PAT (net of Tax)

NNO is Net Non-Operating Obligations (debt) calculated as Non-Operating debt – Non-Operating Assets

Why is it important to breakdown and understand why the ROE can be low. While most of the times, it could be due to the bad business dynamics and low Return on Operating Assets (RNOA), sometimes it can be misleading for a great company due to the high non-operating assets like Marketable securities or investments present in the company`s balance sheet.

Lets consider Jubilant Foodworks balance sheet in India and calculate the Non-Operating return and how it reduces the ROE. Consider year 2016 data:

Consider FY16,

Return on Operating Assets – 191/(1074-475)=31% which is pretty good from a business model standpoint. Now lets calculate Return on Non-Operating assets,

NNO = Net Non-Operating Obligations

= Non-Operating Liabilities – Non-Operating Assets

= 0– 160 Crore Rupees

= -160 Crore Rupees

Average Equity = 798 Crore Rupees

FLEV = -202 Cr/ 798 Cr = -0.2 (ratio)

NNE = NOPAT – PAT = 191 Crore – 107 Crore = 84 Crores

NNEP = 84/-202 Crore = -0.525

Spread = RNOA – NNEP = 0.31 + 0.525 = 0.83

Non-Operating Return = FLEV X Spread

= -0.20 * 0.83 = -17%

ROE for Jubilant Foodworks in 2016 was = PAT/ Equity = 104/798= 13%

ROE can also be calculated as = RNOA + Non-Operating Return

=31% + (-17%)

= 14%

Consider FY17,

Return on Net Operating Assets (RNOA) = NOPAT/ Avg Net Op Assets

= 77 /(1048-463)= 13%

NNO = Net Non-Operating Obligations

= Non-Operating Liabilities – Non-Operating Assets

= 20– 170 Crore Rupees

= -146 Crore Rupees

Average Equity = 805 Crore Rupees

FLEV = -146 Cr/ 805 Cr = -0.18 (ratio)

NNE = NOPAT – PAT = 77 Crore – 67 Crore = 10 Crores

NNEP = 10/-174 Crore = -0.057

Spread = RNOA – NNEP = 0.13 + 0.057 = 0.187

Non-Operating Return = FLEV X Spread

= -0.18 * 0.187 = -3.3%

ROE for Jubilant Foodworks in 2017 was = PAT/ Equity = 67/805 = 8%

ROE can also be calculated as = RNOA + Non-Operating Return

= 13% + (-3.4%) = 9.6%

ROE   = 9.6%

We can see here how the ROE is getting dragged due to the higher Investments in Balance sheet and negligible debt is dragging down the ROE even though the operationally Jubilant has decent Return on Operating Assets (13% in 2017) but the Non-Operating assets is negative due to which the ROE is a drag like 9% in 2017.

Conclusion:

Hence its pertinent to drill down further on arriving at ratios like Return on Equity to really understand what financial maneuvers are causing high ROEs like debt, Buyback and what are causing low ROEs like high Non-Operating assets turnover

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