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Trying to understand Return on Capital (Joel Greenblatt's Magic Formula version)
I've spent enough time researching this question where I feel  comfortable enough providing an answer.  I'll start with the high level fundamentals and work my way down to the specific question that I had. So point #5 is really the starting point for my answer. We want to find companies that are investing their money.  A good company should be reinvesting most of its excess assets so that it can make more money off of them. If a company has too much working capital, then it is not being efficiently reinvested.  That explains why excess working capital can have a negative impact on Return on Capital. But what about the fact that current liabilities in excess of current assets has a positive impact on the Return on Capital calculation?  That is a problem, period.  If current liabilities exceed current assets then the company may have a hard time meeting their short term financial obligations. This could mean borrowing more money, or it could mean something worse - like bankruptcy.  If the company borrows money, then it will have to repay it in the future at higher costs.  This approach could be fine if the company can invest money at a rate of return exceeding the cost of their debt, but to favor debt in the Return on Capital calculation is wrong. That scenario would skew the metric. The company has to overcome this debt. Anyways, this is my understanding, as the amateur investor. My credibility is not even comparable to Greenblatt's credibility, so I have no business calling any part of his calculation wrong. But, in defense of my explanation, Greenblatt doesn't get into these gritty details so I don't know that he allowed current liabilities in excess of current assets to have a positive impact on his Return on Capital calculation.