return on invested capital formula, explanation, description and theory

The return on invested capital is a more effective financial ratio used in the financial analysis of a company. A company's return on invested capital ratio can be used to assess its growth.

Additionally, ROIC can be used for the valuation analysis of a company. ROIC assists to make better decisions about the company. 

What is Return On Invested Capital (ROIC)?

Return on invested capital or ROIC is a profitability ratio that measures how effectively a company earns profits using the investor’s fund. ROIC evaluates the percentage of return earned on invested capital.

The ROIC ratio is used by benchmarking companies to determine the value of other businesses. ROIC is widely used to assess the effectiveness of capital allocation due to the widespread perception that a quality company must consistently generate positive value.

ROIC Formula

Return on invested capital is an important financial metric that is calculated by Net operating profit after tax (NOPAT) divided by invested capital. Hence, the ROIC formula is given below -

Return On Invested Capital = Net Operating Profit After Tax / Invested Capital

NOPAT (Net Operating Profit After Tax) 

NOPAT is after-tax operating cash that a business generates after taxes and makes available to all investors, including debt holders and shareholders. While analyzing the financial statements of a company, Investors often compare net income but net income does not always reflect the actual performance of a company’s operation. 

Whereas NOPAT is a more accurate metric that standardizes the measurement since it represents the amount of profit a company would make if it had no debt and no financial assets. NOPAT is a representation of the income a company would have in the absence of taxes. It provides a more accurate picture of a company's profit due to the exact amount of operating cash generated.

Invested Capital

Invested capital is used day to day operation of a business including expansion and purchase of fixed assets. Invested capital is the amount of money invested by shareholders and debt holders of a company. The shareholders invest in the company’s equity and debt holders invest in short-term or long-term debentures.

How to calculate ROIC with an example?

Here are the steps to use to calculate ROIC with an example. ABC Private Limited has Rs. 50,000 on its income statement as its EBIT and its marginal tax rate is 30%. The company has Rs. 5,000 in short-term debt and Rs. 35,000 in long-term debt and Rs. 55,000 in equity financing. It has 5,000 in retained earnings, 3,000 from cash from financing, and 1,000 from cash from investing.

The first step is to calculate NOPAT,

NOPAT Formula = EBIT(1-t), t = Marginal tax rate

On a company's Income statement, we can find the item Earnings Before Interest and Taxes (EBIT).

The marginal tax rate is the tax rate a company pays on its last rupee of income.

Again, NOPAT Formula = EBIT(1-t)

NOPAT = ₹50,000(1-30%) = ₹50,000×0.7

NOPAT = 35,000

The second step is to calculate Invested Capital,

Invested Capital Formula = Current Liabilities + Long-Term Debt + Common Stock + Retained Earnings + Cash from financing + Cash from investing.

To calculate the invested capital, we require a company's balance sheet and cash flow statement.

The balance sheet's items are current liabilities, long-term debt, common stock, and retained earnings.

Whereas, cash from financing and cash from investing can be seen on the cash flow statement.

Invested Capital = ₹5,000+₹35,000+₹55,000+₹5,000+₹3,000+₹1,000 = ₹1,04,000

Now calculate, ROIC = NOPAT/Invested Capital

ROIC = ₹35,000/₹1,04,000

ROIC = 33.65%

For instance, if the ROIC is 33.65%, that tells us the company earns ₹33.65 of net earnings with each ₹100 invested in the company.

What does Return On Invested Capital interpret?

Return on invested capital is used to evaluate a company's efficiency in allocating capital to profitable investments. ROIC is always calculated as a percentage and is usually expressed as an annualized or trailing 12-month value.

ROIC should be compared to the company's weighted average cost of capital (WACC). Hence the WACC is the average after-tax cost of a firm's capital, it should be compared to ROIC. Investors analyze ROIC and ROE to make better decisions.

If the ROIC is greater than the company's WACC, it indicates Value is being created and these companies will trade at a premium. If the ROIC is lower than the company's WACC, they are eroding value with their investment choices and should adjust their parameters.

ROIC is a crucial ratio and gives valuable insight into the company. Hence, it is important to compare companies within the same sector such as Oil rigs or manufacturing semiconductors that are much more capital-intensive than those requiring less equipment.

What is a good Return On Invested Capital ratio?

There are a few companies that work at zero return, whose rate return on the cost of capital is inside the predefined assessment mistake, which for this situation is 2%. Hence, ROIC should be greater than 2%, creating value for a company.

Generally, the higher the return on invested capital, the more likely the company is to achieve sustainable long-term value creation.

What are the limitations of ROIC?

This metric's main drawback is that it provides no information about the area of the business that is producing value. 

The outcome can be even more ambiguous if you base your computation on net income (without dividends) rather than NOPAT because the return might be the consequence of a single, one-time event.

ROIC provides the necessary context for other metrics such as the price-to-earnings (P/E) ratio. When seen in isolation, the P/E ratio may indicate that a firm is oversold, but the reduction may really be due to a decrease in the rate at which the company is creating value for its owners (or at all). 

However, even if their P/E ratios appear unrealistically high, businesses that continuously provide high rates of return on capital invested likely deserve to trade at a premium relative to other equities.

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