All You Need To Know About Return On Invested Capital

Return on invested capital (ROIC) measures a company’s investment profitability. It compares investment returns to the total capital used, including debt and equity. As a result, ROIC helps assess a company’s stock valuation.

Analyzing a company’s financial statements and performing basic calculations can determine if its stock is overvalued or undervalued compared to its peers. This article simplifies Return on Invested Capital calculation, provides insights for investors, and its limitations.

What is ROIC?

Return on Invested Capital is a metric that measures how efficiently a company utilizes its capital to generate profitable returns for shareholders and debt lenders. Considering the entire balance sheet and income statement, ROIC is valuable for investors. It incorporates both debt and equity to assess a company’s capital structure.

In essence, ROIC answers the question, “How much return does the company generate for each rupee invested?” Although the Return on Invested Capital is presented as a percentage, it is a tool for evaluating and comparing a company’s profitability with similar companies.

However, one of the primary purposes of tracking ROIC is to assess the management team’s capital allocation decisions. In the field of corporate finance, common capital allocation strategies include:

• Mergers and Acquisitions (M&A)
• Sales and Marketing (S&M) Strategies
• Targeted Advertising Campaigns
• Market and geographic expansion

How to Calculate Return on Invested Capital?

Calculating ROIC involves the following steps:

1. Determine the company’s NOPAT (Net Operating Profit After Tax) or EBIAT (Earnings Before Interest After Tax).
2. Calculate the Average Invested Capital, which includes Fixed Assets and Net Working Capital.
3. Divide the NOPAT by the Invested Capital.

ROIC formula

Return on Invested Capital is calculated by dividing a company’s net operating profit after tax (NOPAT) by its average invested capital.

ROIC = NOPAT ÷ Average Invested Capital

Key Components of ROIC

The calculation of Return on Invested Capital involves two key components: NOPAT and invested capital. NOPAT, which stands for “Net Operating Profit After Tax” or “EBIAT” (Earnings Before Interest After Tax), represents the tax-adjusted operating income (EBIT) of the company.

On the other hand, invested capital is the sum of fixed assets and net working capital (NWC). 

NOPAT = EBIT × (1 – Tax Rate %) Invested Capital = Fixed Assets + Net Working Capital (NWC)

When considering invested capital, there are two perspectives, but they ultimately yield the same result due to the principles of double-entry accounting.

Note: Double-entry accounting: Accurate system with debit and credit entries to maintain balance and financial records.

1. Net Working Capital (NWC) : It refers to the net assets required for the business’s day-to-day operations.
2. Capital Expenditure (Capex): This represents the funding provided by creditors and shareholders to finance the acquisition of the company’s assets, categorized as either growth or maintenance capex.

Another simpler approach combines net debt and equity from the balance sheet to calculate invested capital. Cash and cash equivalents (such as marketable securities) are excluded from operating assets since they are considered idle on the balance sheet and not directly involved in the company’s core operations. Similarly, debt and interest-bearing securities are not regarded as operating liabilities and are therefore disregarded in the computation.

Example of calculation of ROIC

Let’s say EDC company has an EBIT (Earnings Before Interest and Taxes) of ₹10,00,000 and a tax rate of 30%. Its fixed assets amount to ₹25,00,000, and its net working capital is ₹5,00,000.

1. Calculate NOPAT: NOPAT = EBIT x (1 – Tax Rate %) NOPAT = ₹10,00,000 x (1 – 0.30) = ₹7,00,000

2. Calculate Invested Capital: Invested Capital = Fixed Assets + Net Working Capital (NWC) = ₹25,00,000 + ₹5,00,000 = ₹30,00,000

3. Calculate ROIC:

ROIC = NOPAT / Invested Capital ROIC = ₹7,00,000 ÷ ₹30,00,000 ≈ 0.2333 or 23.33%

In this example, the ROIC of the company is approximately 23.33%. An alternate way to calculate Return on Invested Capital. ROIC can also be expressed as

ROIC= (Net Income – Dividends) / (debt + equity)

The formula evaluates total capital, the sum of a company’s debt and equity. There are several methods for calculating this value. One approach is subtracting cash and non-interest-bearing current liabilities (such as tax and accounts payable) from total assets.

Calculation of Return on Invested Capital Example (Alternate Approach)

Let’s consider XYE company with a net income of ₹10,00,000 and dividends of ₹1,50,000.  The company’s total debt is ₹5,00,000, and its equity value is ₹15,00,000.

1. Calculate the numerator: Net income – dividends: ₹10,00,000 – ₹1,50,000 = ₹8,50,000

2. Calculate the denominator: Debt + equity = ₹5,00,000 + ₹15,00,000 = ₹20,00,000

3. Calculate ROIC:

ROIC = (Net income – dividends) ÷ (Debt + Equity) : ₹8,50,000 ÷₹20,00,000 ≈ 0.425 or 42.5%

In this example, the ROIC of the company is approximately 42.5%.

ROIC as an Investment Decision Tool: Comparing ROIC to WACC

A high Return on Invested Capital suggests profitable investments by management. However, comparing ROIC to the cost of capital is crucial for a comprehensive analysis. Investors can determine a business’s financing costs across debt and equity by calculating the weighted average cost of capital (WACC),

If a company’s ROIC exceeds its WACC, it indicates shareholder value creation. Conversely, if ROIC is lower than WACC, the company spends more on financing than it generates in profits.

Importance of Return on Invested Capital

ROIC is essential because it provides valuable insights into a company’s ability to generate profitable returns on invested capital.

1. Measure of Efficiency: ROIC measures how effectively a company utilizes its capital to generate profits. It indicates how much return the company earns for each dollar invested.
2. Assessing Profitability: ROIC helps assess a company’s profitability by comparing it to peer companies or industry benchmarks. A higher ROIC indicates better profitability and efficient capital allocation.
3. Management Performance: Tracking ROIC helps evaluate the team’s judgment and effectiveness in allocating capital. A consistently high ROIC demonstrates competent management and their ability to pursue profitable opportunities.
4. Attracting Investors: ROIC is a crucial Key Performance Indicator (KPI) for attracting external investors. It acts as validation that the company can generate returns and effectively utilize capital, instilling confidence in potential investors.

Limitations of Return on Invested Capital

1. Industry Variations: ROIC may not be directly comparable across industries due to different capital intensities and profit margins.
2. Historical Perspective: ROIC is based on past data and may not reflect current market conditions or future changes.
3. Capital Structure Bias: ROIC overlooks the impact of capital structure and assumes a constant cost of debt and equity.
4. Intangible Assets: ROIC may not fully capture the value created by intangible assets like brand recognition or intellectual property.
5. Lack of Context: ROIC should be evaluated regarding industry dynamics, competition, and company-specific factors.
6. Potential Manipulation: ROIC can be influenced by accounting practices, requiring scrutiny of underlying data and methods.

How to Improve Return on Invested Capital?

Businesses can enhance their Return on Invested Capital, drive profitability, and create a solid foundation for sustainable growth by implementing these 4 strategies.

1. Invest in efficient software systems: Implement advanced software for better inventory management and operational efficiencies.
2. Increase profitability through various strategies: Explore opportunities to generate more profit, such as pricing adjustments and effective marketing.
3. Reduce investment outlay and assess expansion plans: Carefully evaluate and prioritize investment decisions for optimal returns.
4. Optimize debt structure for lower costs: Review loan structures and consolidate debt to reduce servicing expenses.
5. Efficiently manage working capital expenditure: Streamline inventory, payroll, and operational processes to minimize working capital needs.
6. Optimize labor force and consider automation: Maximize productivity by aligning skills, investing in training, and leveraging automation technologies.
7. Cut fixed overheads and optimize equipment usage: Identify cost-saving measures for overhead expenses and optimize equipment utilization.

Final Words

Assessing a company’s profitability and capital efficiency is crucial, and Return on Invested Capital (ROIC) is a key metric used for this purpose. Investors can evaluate a company’s potential and value by comparing returns to invested capital. However, it’s essential to keep in mind that there are limitations to this metric, such as industry variations and historical perspectives.

To improve ROIC, businesses can optimize their capital structure, implement efficient software, and manage working capital effectively. These strategies can drive sustainable growth and profitability for the company.

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