Time for Australian political commentators to dust off their finance textbooks as financial metrics have entered the political debate. In a contentious Senate hearing Greens Senator Nick McKim threatened Woolworths (ASX: WOW) CEO Brad Banducci with six months in jail for not knowing the firm’s return on equity (“ROE”). Banducci responded that he was focused on the firm’s return on invested capital (“ROIC”) as the preferred measure to assess performance of the company. Leaving politics aside lets focus on the financial metrics and what they mean.

Return on equity

The ROE is a measure of profitability based on the capital that shareholders have invested in the company. To calculate the ROE the net income is divided by shareholder equity.

Net income is the profits generated by the company. Shareholder equity is the total amount of capital that has been invested in a company by the owners of company – the shareholders. To calculate shareholders equity requires taking all the assets on the balance sheet and subtracting the liabilities. This figure is supposed to represent the money that could be returned to shareholders if the company decided to call it a day and sell everything, pay back all the money owed and return the rest to shareholders. A normally unrealistic step that might have crossed Banducci’s mind during the hearing.

Woolworths’ balance sheet at the end of 2023 shows total assets of $33.15B and total liabilities of $27.92B. Almost half of the assets are made up of property, plant and equipment which makes sense for a company like Woolworths that relies on physical assets like warehouses and stores and transportation assets to get grocercies to customers. Other large components of Woolworths’ assets include inventories which are the products they are yet to sell and goodwill which is an accounting term representing an intangible asset when a firm pays a premium over the net assets of a company that is acquired. The liability side for Woolworths is mostly made up of long-term debt and lease obligations.

This detour into the balance sheet serves a purpose. Looking at assets and liabilities is looking into the past. Property, plant and equipment could have been acquired decades ago and slowly depreciated over time. Goodwill is retained from acquisitions that occurred in a different operating environment and under different management. Corporate debt and leases on property and equipment are generally long-term. And this is the flaw in ROE. In using the measure we may not be measuring how a company is currently operating and how it is responding to the current environment.

Return on invested capital

The ROIC is a mesure of how efficiently a company is investing capital by measuring what return is generated off investments in the business. It is not surprising that Banducci is focused on this measure since this is what a CEO does on days that don’t involve Senate testimony. Above all else a CEO is responsible for allocating capital in profitable ways to generate returns for shareholders.

The calculatation of the ROIC involves dividing the net operating profit after tax (“NOPAT”) by the invested capital. Invested capital is the total amount of capital raised by a company by issuing shares and debt.

When our analysts identify a sustainable competitive advantage or moat they expect the ROIC to exceed the cost of the invested capital which is measured by a metric called the weighted average cost of capital (“WACC”). This is a sign that a company has a sustainable competitive advantage as they are able to source capital at a cost that is less than the return earned when investing it in the business.

The advantage of ROIC is that it is an assessment of how the company is operating in the current environment. It is a measure of the return that the company is currently earning on the capital invested and not accounting for legacy assets and liabilities. When compared to the WACC it shows us if the company is adding to shareholder value. As a measure focused on the recent past this is a smart way to evaluate a CEO. We want to know if the CEO is allocating capital effectively and not focus on decisions that occurred in the more distant past.

What financial metrics indicate price gouging?

The whole point of this back in forth in the Senate was the charge that Coles (ASX: COL) and Woolworths are engaging in price gouging. Prices do play a role in both ROE and ROIC since both measures use income in the calculation. All things being equal higher prices mean more income. In an inflationary environment we need to look at changes in the prices charged and changes in the prices paid to run the business and purchase goods and services.

A more precise measure would be to look at the margin earned on sales. Higher margins are positives for companies. Sustaining higher margins than competitors may indicate a sustainable competitive advantage as competition generally leads to lower prices.

The net margin is the difference between revenue and profit. That includes both the direct costs of supplying a good and service and all the centralised costs of running a business. The gross margin is the difference between revenue and the direct costs of supplying a good or service.

The grocery business is notoriously low margin. A grocery store doesn’t make a lot on each item that is sold and instead relies on volume to drive profits. That is why scale matters. A larger operation spreads the fixed costs associated with the business over a larger customer base. There are also scale efficiencies to the direct costs of sourcing food as the company can negotiate better prices with suppliers. This has been a criticism of Coles and Woolworths. In essence the charge is that they are hurting farmers by paying low prices.

There is little indication there is price gouging in Woolworths’ financial statements. Over the past 5 years Woolworths’ operating margin has averaged 28.70% and the net margin has averaged 5.01%. In 2023 the gross margin was 25.55% and the net margin 2.52%.

How to interpret the back and forth between Banducci and Senator McKim

It is up to you to determine if this was populist political theature or an important debate about the power of the major grocery chains and how they impact Australian consumers. No matter which camp you fall into we can put our investing hats on to assess some of the points made in the hearing.

Senator McKim’s questioning about ROE was quickly followed with a comparison to the ROE earned by banks. And yes, Woolworths’ ROE is higher. As investors we should know that comparing financial metrics across different industries is a futile exercise. Companies in different industries are operating in different environments. Some types of business are asset heavy and some aren’t. Some naturally earn high margins and some don’t.

Comparing metrics across different industries for politicians may be more fruitful. If there is any industry hated by the public more that grocery chains right now it may be the banks.

The larger point is that any financial metric does not give us a full picture of how a company is doing. We need the context that comes from understanding both the business and the competive environment under which it operates to make any metric useful. Perhaps that is the biggest lesson for investors.

We are inunindated with data. To be a successful investor requires understanding the underlying drivers of commonly used financial metrics. We need to understand the business and the industries we invest in. Being informed is the goal. Perhaps a lesson we can carry over to the way we approach our responsibilities as citizens.