Calculate the return on invested capital with CalcoPolis.
Table of Contents
- What does return on invested capital mean?
- How to calculate return on invested capital?
- Return on Invested Capital formula
- Invested Capital
- Alternative ROIC formula
- When to use the ROIC calculator?
- How to use ROIC to determine the efficiency of working capital?
- How to use ROIC for company valuation?
- How to use ROIC to determine if rising capital is a good option?
- How to use ROIC to compare companies?
- When not to use this metric?
- ROIC undermines long-term investments
- New companies usually have low ROIC.
- ROIC gives just a broad overview
- What is a good ROIC?
- Example ROIC calculation
- Alternative financial metrics
What does return on invested capital mean?
ROIC is an advanced financial metric for determining how efficiently a company utilizes its capital to generate profits. Invested capital can be in the form of equity and current liabilities.
Calculating ROIC allows one to determine whether the company successfully creates value for its shareholders.
- ROIC allows us to estimate the amount of cash a company makes from all of its investments.
- Since this metric considers both liabilities and equity, it is a more accurate metric than ROE
- If the ROIC value is higher than the average cost of capital, the company creates value from its investments. Otherwise, it's a net value-destroyer.
How to calculate return on invested capital?
Return on Invested Capital formula
ROIC = NOPAT / invested capital
NOPAT = EBIT * (1 - tax_rate/100%)
Capital acquired by the company can have a form of equity and debt. So it can be expressed by this simple equation:
Invested_capital = debt + equity
Alternative ROIC formula
Using the information above, we can derive an alternative equation for calculating ROIC:
ROIC = [EBIT * (1 - tax rate)] / (debt + equity)
ROIC = (net income – dividends) / (debt + equity)
All the data needed for calculating ROIC can be found in the company's income statement. However, the effective tax rate is sometimes not presented directly, but it can be easily calculated by dividing a company's tax expense by net income.
Key takeaways from the equations
- ROIC can be increased either by an increase in EBIT or tax optimization
- High liabilities can reduce the ROIC ratio if the money is not used efficiently
When to use the ROIC calculator?
However, ROIC is a very accurate financial metric for evaluating company profitability. Understanding which context is the best option for investors is important.
How to use ROIC to determine the efficiency of working capital?
ROIC clearly indicates how successful a company is in investing capital to it has access. This metric is especially for companies that use debt as leverage since alternative metrics such as ROE doesn't consider the company's debt.
How to use ROIC for company valuation?
Although this single metric is not enough to find the company's real value, it's an essential component of the financial analysis of the enterprise. There is so much accounting information that this ratio reveals, so analysis without considering it is not complete.
How to use ROIC to determine if rising capital is a good option?
Since the fundamental question answered by the ROIC ratio is "how efficiently a company utilizes current assets?" - this metric can be used to decide if the additional influx of capital could be efficiently used for value creation.
This issue could be answered by comparing ROIC to the Weighted Average Cost of Capital (WACC). If ROIC is higher than WACC, it's a sign that additional investment could be turned into profits. Otherwise, it is unlikely that a particular company will use extra capital efficiently.
How to use ROIC to compare companies?
Like other business metrics, ROIC allows you to compare enterprises. It is not only more accurate than many alternatives like ROI or ROE, but also all necessary information is available in the income statement and balance sheet. Because of that, the comparison of ventures using this indicator is not only simple but quick as well.
When not to use this metric?
Although ROIC has a vital place in fundamental business analysis, it has its limitations. So to use this ratio properly, there are a few situations when other metrics should be applied.
ROIC undermines long-term investments
Doing business will be much easier if all the investments would pay for themselves immediately. Often projects tend to bring profits after a few years.
Since this metric is focused on the fiscal year, long-term investments will drive down the ROIC value. So by relying solely on this indicator, you can miss a good investment opportunity.
New companies usually have low ROIC.
For similar reasons, newly established businesses tend to have low or negative ROIC percentages. Each venture needs time to bring profits, so applying this metric at an early stage of the company or startup may be misleading.
ROIC gives just a broad overview
Although the discussed indicator provides important information, it is essential to note that it tells nothing about what segment of the business is creating value.
What is a good ROIC?
It is hard to give a straight answer; we could answer the same as we answer what a good ROE is. The higher the percentage value of ROIC, the better, and much depends on the industry and how your business is doing in relation to its competitors.
However, there is a good indication that gives you a clear answer in the case of a particular company. Since ROIC measures how efficiently a company uses invested capital, if the average cost of capital (WACC) is lower than the ROIC percentage, the current ROIC level could be considered reasonable.
Example ROIC calculation
In order to illustrate how to work out the return on invested capital for a particular company, let's go through an example. To simplify the numbers, let's analyze an imaginary corporation called ACME Corp.
In the fiscal year of 2021, ACME generated 10 million in revenue and 1,7 million in operating profit (EBIT). The income tax rate was 20%. Using this data, we can calculate NOPAT, the ROIC formula's numerator.
NOPAT = EBIT * (1-tax_rate/100%) = $1,700,000 * (1 - 20/100) = $1,360,000
The company has 5 million equity in the form of initial shareholder's investment and 2 million of long-term debt. So total invested capital on disposal of the company can be calculated as follows:
Invested_capital = equity + debt = $5,000,000 + $2,000,000 = $7,000,000
Now we have all the data for the final calculation:
ROIC = NOPAT / invested_capital * 100% = ($1,360,000 / $7,000,000) * 100% = 19,4%
Alternative financial metrics
If you are looking for more straightforward metrics, you can visit our ROI calculator.