244  Analyzing Performance Once you have calculated the historical drivers of ROIC, compare them with the ROIC drivers of other companies in the same industry. You can then weigh this perspective against your analysis of the industry structure (op- portunities for differentiation, barriers to entry or exit, etc.) and a qualitative assessment of the company’s strengths and weaknesses. To illustrate, let’s examine the difference between Costco and its peers. In 2018, Costco’s ROIC with goodwill equaled 17.7 percent, compared with its peers’ median of 11.6 percent. The difference is somewhat smaller with- out goodwill, because Costco had no goodwill. You might ask what drives Costco’s higher ROIC. Costco has an unusual business model for a retailer. It doesn’t mark up its costs as much as other retailers, leading to a higher cost of sales relative to revenues. It makes up for that with lower selling and gen- eral expenses. For example, its warehouse format has much lower deprecia- tion, and its cost to stock shelves is lower because it doesn’t put items on the shelves individually but instead uses the manufacturers’ containers. Costco also sells larger sizes of its products with a smaller assortment to manage. Despite the lower selling and general expenses, it still ends up with a lower operating profit margin (3.2 percent, versus 5.1 percent). It makes up for this with higher capital productivity—primarily much lower fixed assets relative to sales. Line Item Analysis  A comprehensive valuation model will convert every line item in the company’s financial statements into some type of ratio. For the income statement, most items are taken as a percentage of sales. (Exceptions exist: operating cash taxes, for instance, should be calculated as a percentage of pretax operating profits, not as a percentage of sales.) For the balance sheet, each line item can also be taken as a percentage of revenues (or as a percentage of cost of goods sold for inventories and pay- ables, to avoid distortion caused by changing prices). For operating current assets and liabilities, you can also convert each line item into days, using the following formula: Days Balance Sheet Item Revenues = × 365 If the business is seasonal, operating ratios such as inventories should be cal- culated using quarterly data. The differences can be quite substantial. The use of days lends itself to a simple operational interpretation. How much cash is tied up in the business, and for how long? As Exhibit 12.4 demonstrates, Costco and its peers have negative working capital, with Costco’s somewhat lower. Costco’s product selection and business model results in lower levels of inventory and accounts payable. In 2018, it had only 30.9 days of inventory, versus 52.7 for its peers. In other words, goods don’t stay on Costco’s shelves Analyzing Returns on Invested Capital  245 as long as they do at its peers’. Costco also has lower accounts payable days (30.9 versus 54.4 in 2018). This means it pays its suppliers faster, perhaps to get better prices. Operating Analysis Using Nonfinancial Drivers  In an external analysis, ratios are often confined to financial performance. If you are working from inside a company, however, or if the company releases operating data, link operating drivers directly to return on invested capital. By evaluating the op- erating drivers, you can better assess whether any differences in financial per- formance between competitors are sustainable. Consider airlines, which are required for safety reasons to release a tre- mendous amount of operating data. Exhibit 12.5 details financial and operat- ing data for two U.S. carriers we’ll refer to as Airline A and Airline B between 2016 and 2018. Operating statistics include the number of employees, mea- sured using full-time equivalents, and available seat-miles (ASMs), the com- mon measurement of capacity for U.S. airlines. Exhibit 12.6 transforms the data presented in Exhibit 12.5 into the oper- ating-margin branch on the ROIC tree. Operating margin (operating profit divided by revenues) equals 9.1 percent for Airline A and 9.4 percent for Air- line B. For airlines, operating margin is driven by three primary accounts: aircraft fuel, labor expenses, and other expenses. At first glance, it appears that Airlines A and B have similar labor costs. Labor expenses as a percentage of revenues average 27.7 percent for Airline A and 26.7 percent for Airline B. But EXHIBIT 12.4  Costco versus Peer Group: Working Capital in Days on Hand Number of days of revenues or cost of sales1 Costco Peer Group 2016 2017 2018 2016 2017 2018 Operating cash 7.2 7.0 7.0 6.7 6.1 6.1 Accounts receivable, net 3.8 3.8 4.0 4.2 4.2 4.6 Inventory 31.7 30.7 30.9 54.3 52.3 52.7 Other current assets 0.8 0.8 0.8 1.5 1.4 1.6 Operating current assets2 39.3 38.2 38.6 49.6 50.1 51.7 Accounts payable 29.5 28.1 30.9 48.2 50.6 54.4 Accrued salaries and benefits 7.8 7.5 7.3 4.8 5.3 5.7 Other current liabilities3 12.3 13.2 13.8 12.8 12.1 11.8 Operating current liabilities2 45.7 45.1 48.0 51.7 57.1 57.7 Working capital (6.4) (6.9) (9.3) (2.1) (7.0) (6.0) 1 Days in inventory and accounts payable computed using cost of sales. Everything else computed using revenues. Measured using beginning- and end-of-year working capital account. 2 Operating current assets and operating current liabilities do not equal the sum of individual accounts. Instead they are denoted in days of revenue. 3 Other current liabilities for Costco include accrued member rewards and deferred membership fees.