Understanding McDonald's: Comprehensive company primer and profitability analysis (Part 16 of 21)

(Continued from Part 15)

According to company management, ROIIC is a measure used over one-year and three-year periods to evaluate the overall profitability of the business, the effectiveness of capital deployed, and future capital allocation. This measure is calculated using operating income and constant foreign exchange rates to exclude the impact of foreign currency translation.

Market Realist’s interpretation is that management is simply taking incremental EBITDA over incremental capital expenditures to determine the effectiveness of their near-term investments. Since capital expenditures can be managed annually, comparing both the numerator and denominator of this ratio on one-year and three-year bases is probably helpful. The effects of capital expenditures are also most likely to be seen in future years, so this ratio would be more effective if it incorporated a lagged variable.

Here’s the company’s take on how to calculate the ratio.

The numerator is the company’s incremental operating income plus depreciation and amortization from the base period, while the denominator is the weighted-average cash used for investing activities during the applicable one- or three-year period. The weighted-average cash used for investing activities is based on a weighting applied quarterly. These weightings are used to reflect the estimated contribution of each quarter’s investing activities to incremental operating income. For example, fourth quarter 2012 investing activities are weighted less because the assets purchased have only recently been deployed and would have generated little incremental operating income (12.5% of fourth quarter 2012 investing activities are included in the one-year and three-year calculations). In contrast, fourth quarter 2011 is heavily weighted because the assets purchased were deployed more than 12 months ago and therefore have a full-year impact on 2012 operating income with little or no impact on the base period. (87.5% and 100.0% of fourth quarter 2011 investing activities are included in the one-year and three-year calculations, respectively.) Management believes that weighting cash used for investing activities provides a more accurate reflection of the relationship between its investments and returns than a simple average.

The reconciliations to the most comparable measurements, in accordance with accounting principles generally accepted in the U.S., for the numerator and denominator of the one-year and three-year ROIIC are as follows.

You can also find this diagram in the company’s official annual 10-K report.

Continue to Part 17

Browse this series on Market Realist:

• Part 1 - McDonald’s global business model, the “three-legged stool”

• Part 2 - What is a franchise and how do McDonald’s franchise agreements work?

• Part 3 - How important are franchise revenues to McDonald’s?