Definition
Return on Invested Capital (ROIC) defined as a profitability and efficiency of users to invested capital to generate return.
There is common among investors as well as analysts, to determine the extent to which a company is creating value for its stakeholders in relation to the capital employed in its business.
ROIC is used as a tool for evaluating the quality of the management and efficiency of the use of resources within any company.
It may be argued that it indicates to investors whether the company is generating returns greater than or lesser than it’s cost of capital.
Formula for ROIC
The formula for calculating ROIC is:
ROIC = (NOPAT ÷ Adjusted Taxes) = (Invested Capital ÷ Total Stock Returns)
Where:
- Net Operating Profit After Taxes (NOPAT): This is operating profit of a company after less the tax. It is calculated as:
- Invested Capital: This is the amount of capital that a company needs to invest so as to start generating its income from business. It encompasses equity and gross at debt register, less non-operating assets such as cash and equivalents.
How to Calculate ROIC
To calculate ROIC, follow these steps:
- Determine NOPAT: From the income statement derive the operating income and then subtract taxes on the basis of the tax rate applicable.
Example:
Operating Income: ₹50,00,000
Tax Rate: 30%
- Calculate Invested Capital: Total up total assets, then decrease it by present liabilities, except for short term ones.
Example:
Total Assets: ₹80,00,000
Current Liabilities (excluding debt): ₹20,00,000
- Apply the Formula: Both provisions should be exhibit; For the first: Divide NOPAT by Invested Capital.
Example:
ROIC = 58.33%
What ROIC Tells Investors
Performance Benchmark:
- ROIC is also useful in comparing with other companies because companies with high ROIC mean the company is generating a lot of returns on its capital. If ROIC is greater than the company’s WACC then the business is generating value for its shareholders.
Operational Efficiency:
- ROIC is useful for demonstrating to investors how effectively the management deals with capital to make profit.
Comparative Analysis:
- Due to ROIC, investors can easily analyze industries so that they can determine companies that are more efficient in their use of capital and profitable.
Sustainability:
- When ROIC is high consistently it means that the company has a sustainable competitive edge in terms of resource management.
Limitations of ROIC
While ROIC is a valuable metric, it has some limitations:
Complex Calculation:
- Civilizing for adjusted NOPAT and invested capital can sometimes be tricky and not very clear-cut.
Accounting Discrepancies:
- Research evidence shows that differences in accounting methodologies between firms create some discrepancies in ROIC estimates.
Short-Term Focus:
- ROIC does not consider the future strategic investments and resources that have not reported any return.
Industry-Specific Metrics:
- ROIC is may not be a right measure for Industries with large base of assets or industries associated with business cycles.
How to Use ROIC
Assessing Value Creation:
- In this screening, WACC can be compared to ROIC of the company. If ROIC > WACC, it means that the company is making value.
Identifying Trends:
- Use ROIC over time to measure changes in the use of capital that may be a sign of increase/decrease in efficiency.
Comparative Valuation:
- Mobile ROIC should be used in conjunction with other ratios like ROE and EBITDA to get a Birds Eye view of its financial health.
Strategic Decision-Making:
- It is also critical in terms of assessing potential consequences of capital allocation decisions for ROIC.
ROIC vs. Other Valuation Metrics
ROIC vs. ROE:
- ROIC takes into account the equity as well as the debt, whilst the ROE concentrates on the equity alone.
ROIC vs. ROI:
- In the same way, ROIC equals ROIC and BIC and is broader than ROI since it does not include non-operating assets.
ROIC vs. EBITDA Margin:
- ROIC compares profitability to capital investments made, while the EBITDA margin focuses on operational profitability to revenue.
Example of ROIC
Let’s consider a hypothetical company:
- Operating Income: ₹50,00,000
- Tax Rate: 30%
- Total Assets: ₹100,00,000
- Current Liabilities (excluding debt): ₹30,00,000
Step 1: Calculate NOPAT
Step 2: Determine Invested Capital
Step 3: Calculate ROIC
ROIC = 50%
Conclusion
ROIC is an important measure as it determines whether a company can generate a return on its capital invested.
Although it provides one’s insight into the business’s operational efficiency and hence value creation, it will only be useful when considering other financial metrics to take a good investment decision.
It can be understood and its limitations known so that investors may use it in finding the best-performing companies to achieve better outcomes from investments.
Frequently Asked Questions
1.How Can Companies Improve ROIC?
Increase Operational Efficiency: Cost reduction and productivity improvements
Better Asset Use: Optimize the working and fixed capital.
Increased Profit Margin either in terms of Revenue or decreased expense to increase the firm’s NOPAT
Sharpe Capital Allocation: High-Return Projects but avoid leverage
2. What is Good ROIC?
A good ROIC is usually higher compared to the company’s WACC.
ROIC > WACC: The firm has created value.
ROIC < WACC: The company has destroyed value.
For most industries, an ROIC above 10-12% is pretty strong; however, this will depend on industry norms.
3. What is ROIC & How Does It Work?
The Return on Invested Capital or ROIC measures how a firm is using its debt and equity invested capital to create profits. The better is the ROIC, as it means that the better the company is doing at creating value for shareholders. It is earning returns well above its cost of capital.
4. What is Invested Capital (IC) & ROIC Ratio?
Invested Capital (IC) is that money which an enterprise has placed into its core business operation. It means debt, equity, or retained earnings.
ROIC Ratio: This reflects as to what extent a corporation is being able to efficiently generate the profits from an invested capital.