ROIC is a popular profitability ratio. It helps investors measure how well a company is using its invested capital to generate profits.
If you are a stock investor who wants to invest in a company's stock, you must know how the company utilises raised capital from investors. This will help you assess the fundamentals of the company. By knowing this, you can decide whether to invest in the company stock or not.
Understanding a company's financial performance is crucial for investors and stakeholders, and one key metric to consider is Return on Invested Capital (ROIC). In this article, we will dive into the concept of ROIC, a measure that helps determine how efficiently a company is using its capital to generate profits. We'll explore what ROIC is, why it's important, and how it differs from other financial metrics. Additionally, we'll provide a step-by-step guide on how to calculate ROIC, including the necessary components and formula. By the end of this article, you'll have a comprehensive understanding of ROIC and how to use it to assess a company's financial health.
What is Return on Invested Capital (ROIC)?
The acronym ROIC stands for Return on Invested Capital. This financial metric plays a vital role in evaluating a company’s operational efficiency and profitability. Invested capital refers to the funds a company secures through issuing shares or bonds to its shareholders or bondholders. Essentially, it represents the resources pooled for business operations and growth.
ROIC measures how effectively the company utilises these funds to generate returns or profits. By calculating the ratio of net income (after adjustments) to invested capital, ROIC provides insights into the company’s ability to create value for its investors. A higher ROIC signifies that the company is efficiently deploying its capital to achieve profitability, making it an attractive choice for investors.
This metric is especially useful when comparing companies within the same industry, as it highlights which organisations are maximising their shareholder contributions. By understanding ROIC, investors can gauge the financial health and potential growth trajectory of a business. It also assists in determining whether the company is generating sufficient returns relative to the cost of capital it has incurred. In essence, ROIC serves as a crucial benchmark for assessing the return-generating capabilities of a company, ensuring informed decision-making for stakeholders.
Return on Invested Capital Formula
ROIC formula
You can calculate ROIC with this formula:
ROIC = (Net operating profit after tax) / (Average capital invested)
According to this formula, the return on invested capital is equal to the ratio of NOPAT (net operating profit after tax) to average invested capital. What are the different components of this formula? Let us understand them better:
- NOPAT is the company's operating profit after tax. This means it represents the profit available for all the investors who invested in the company.
- Invested capital is the capital the company has raised by selling its shares or issuing debt bonds.
This ratio helps you get a percentage value that tells you how much profit a company can generate with every invested rupee. If the value of ROIC is high, especially above 2%, then the company can be considered highly efficient in using shareholders’ or investors’ capital. When you are planning to invest in a company’s stock, check its ROIC. If it is consistently high, you can expect to get good returns in the long run.
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What are the steps to calculate ROIC?
There are 3 steps for computing return on invested capital. These steps are outlined below:
Step #1: Calculate the value of NOPAT
You can find the NOPAT value with the help of any of the following two formulae:
Simplified formula of NOPAT = Operating profit x (1 – effective tax rate)
Complex formula of NOPAT = (Net income + non-operating income loss – non-operating income gain + interest expense + tax expense) x (1 – effective tax rate)
Step #2: Compute the value of average invested capital
You can compute the average invested capital by adding fixed assets with net working capital and acquired tangibles (which include goodwill).
Its formula is:
Average invested capital = (Invested capital in the beginning) + (Average incremental non-acquired invested capital) + (Adjusted total acquired invested capital)
Invested capital is the capital that was invested when the company started.
Average incremental non-acquired invested capital is the total average value of new capital that has been invested in the company. However, it does not include any capital if there is any acquisition.
You can calculate it using the following formula:
[(Ending invested capital) - (Beginning invested capital) - (Acquired invested capital)] / 2
Adjusted total acquired invested capital is the capital invested as part of any acquisition. This is nothing but invested capital’s time-weighted value.
You can calculate it with the following formula:
(Acquired capital’s value) x (Percentage of the year that the company employed that invested capital)
Average invested capital = Invested capital in the beginning + [{(Ending invested capital) - (Beginning invested capital) - (Acquired invested capital)} / 2] + [(Acquired capital’s value) x (Percentage of the year that the company employed that invested capital)]
Step #3: Division of NOPAT by average invested capital
Once you have calculated the values of both NOPAT and average invested capital, you simply have to divide net operating profit after tax by average invested capital.
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Example of return on invested capital
Now that the meaning and calculation of return on invested capital are clear, let us better illustrate the concept with an example. Let us assume that a business ‘G’ has generated Rs. 80 crore worth of NOPAT in year one. In addition, it has an average investment value of Rs. 800 crore in the same period. Thus:
- NOPAT = Rs. 80 crore
- Average invested capital (IC) = Rs. 800 crore
Now, taking into consideration the values of NOPAT and IC, the return on invested capital can be calculated as 10%.
ROIC = Rs. 80 crore ÷ Rs. 800 crore = 10%
In this example, the 10% ROIC of company G indicates that it has generated Rs. 10 in net earnings per Rs. 100 invested.
What is a good ROIC ratio?
A good ROIC ratio generally exceeds the company’s weighted average cost of capital (WACC). This indicates the firm is generating returns greater than the cost of obtaining capital, reflecting efficient utilisation of resources. An ROIC above 10-15% is considered strong, but this benchmark can vary across industries. Companies with consistently high ROIC are often well-managed and have competitive advantages, making them attractive investment options.
It’s essential to compare ROIC within the same sector, as different industries have distinct capital requirements. For instance, technology firms may achieve higher ROIC due to lower capital needs, while utilities may have lower ratios due to heavy infrastructure investments.
However, ROIC must be analysed over several years to identify trends. A one-off high ROIC could result from extraordinary gains or non-recurring income, which may not represent the firm’s true efficiency.
Moreover, sustainable ROIC growth indicates that the company is reinvesting profits wisely to foster long-term success. Investors should also assess ROIC alongside other metrics like return on equity (ROE) and debt levels to gain a comprehensive view of financial health. In conclusion, a "good" ROIC depends on context, but exceeding WACC and industry norms is a positive sign.
Drawbacks of ROIC
Despite the crucial importance and relevance of ROIC for company investments, the metric does have certain limitations and drawbacks that necessitate further enquiry. Some of its drawbacks are discussed below:
Multiple segments
Numerous companies operate in more than one sector or segment. Some may be capital-intensive, while others may not be. As the ROIC metric takes into account the entire company’s operations, it is often difficult to objectively assess whether all the segments are generating strong returns or if the returns are unevenly distributed.
Industry applicability
ROIC is less applicable to a few industries, such as financial companies, where capital is used in the companies’ products.
Vulnerability to factors that generate misleading ROIC
- Goodwill
Companies with significant goodwill on their balance sheets will show lower ROIC because of a high denominator. If goodwill is written down, adjustments must be made for a ROIC historical analysis. - Capital leases and excess cash
Comparisons in ROIC can be skewed if one company has more capital leases than the other. Thus, for a true comparison, modifications need to be made in the calculation. Excess cash can deflate ROIC and should be subtracted from the net working capital for accurate analysis.
Non-recurring events
Significantly big one-time profits or losses can also distort ROIC. These should be excluded when evaluating normal business operations. To account for big changes, be mindful of variations and anomalies in income statements and balance sheets when undertaking ROIC analysis of multiple competing businesses.
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Why ROIC matters for investment?
By now, it must be clear that ROIC can be an insightful metric for businesses and investors. For businesses, it can help them understand the efficiency of their investments and make changes wherever necessary. And for investors, it is an insight into the operational and financial health of a business. Let us now take a look at a few prominent ways in which ROIC has carved out its importance for investments:
Indicator of success for both parties
ROIC can be utilised to monitor your success if you run a business or you are planning to invest in a business. For example, as an investor, you can assess the ROIC data to understand how your invested business has performed and make strategic investment decisions based on the insights. Similarly, as a business owner, you can utilise the ROIC information to ensure that investor money is being used efficiently to generate more wealth. This also has the benefit of reassuring investors that your business is continually growing and is worth investing in.
Finding optimal investment options
ROIC is a helpful metric in searching for the most optimal investment options. It can help you discover strong performers among various companies. Businesses are always looking for more investors for multiple reasons. ROIC is immensely helpful for investors in sorting companies, comparing them, undertaking historical analysis, and figuring out investment strategies accordingly. For instance, as an investor, you can seek details about a company’s historical earnings and undertake a pro and con analysis to make an informed investment decision.
For businesses, ROIC can help them stand out from the crowd. It is a great way to project the company’s success and earnings along with similar data to show their potential and secure higher investments.
Make better decisions
ROIC is an indicator of success for both the business and the investors. It reassures both sides; investors can know if they want to continue their investment or find other avenues, and businesses can continuously optimise their investment choices. ROIC empowers both sides to clearly understand and protect their returns and measure success to maintain a cordial business relationship without hassle.
Also read: How does fund of funds work?
Limitations of using Return on Invested Capital (ROIC)
ROIC, while insightful, has several limitations. It can be distorted by accounting policies or one-time events like asset sales, affecting accuracy. Differences in capital structure make comparisons across industries challenging. ROIC also relies on precise calculations of invested capital and operating income, which may be subjective or inconsistent across companies. Additionally, it doesn’t account for future growth potential or qualitative factors such as management competence or market conditions. Investors should use ROIC alongside other financial metrics for a well-rounded analysis and avoid relying solely on this ratio to make investment decisions.
Key takeaways
- Definition: ROIC measures how effectively a company utilises its invested capital to generate returns.
- Good ROIC: A good ROIC exceeds the company’s WACC, indicating efficient capital use.
- Industry relevance: Comparisons should be within the same sector due to varying capital requirements.
- Limitations: ROIC may be distorted by accounting practices, one-time events, and subjective calculations.
- Contextual analysis: To ensure accurate insights, investors should examine ROIC trends over time and complement it with other financial metrics for comprehensive evaluation.
Conclusion
An ROIC above 2% is considered a good return on invested capital. If you are an investor, you should first use the ROIC formula to know the ROIC ratio. If it is more than 2%, it means that the business in which you have invested your capital is employing the capital productively and profitably. If the ratio is less than 2%, it means the company is not using the invested capital efficiently.
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