What is Return on Invested Capital?
Return on Invested Capital or ROIC expresses the after-tax, pre-financing profits of a business as a percentage of the capital invested by the business’s capital holders. It is a useful measure of both operational profitability and efficiency of a business.
The metric is also known as ROCE or Return on Capital Employed. These metrics both provide the same result, however, ROIC reviews the efficiency and profitability of returns from the investors perspective rather than the actual investments made by the business.
The formula is expressed as:
ROIC = EBIT * (1-tax rate)/Invested Capital
- EBIT represents the recurring profit from a company’s operations and does not include expenses related to capital structure, such as interest. EBIT is multiplied by 1 minus the tax rate to deduct tax from the operating profits of the business. This can also be expressed as EBIAT, or earnings before interest and after tax, or sometimes ‘unlevered net income’. Money paid out in tax is not available to financiers and the earnings must be adjusted to show this.
- Invested capital represents the net operational assets of the business
Key Learning Points
- Return on Invested Capital (ROIC) is a return ratio which expresses recurring operating profits as a percentage of the company’s net operational assets
- The profit figure used is earnings before interest and taxes or EBIT and is unaffected by capital structure
- Invested capital is calculated as net debt plus equity i.e. the sources of funds to run the day to day operations of the business
- ROIC is often compared to weighted average cost of capital (WACC) as an aid in investment decision making
Let us understand the numerator and denominator for calculating ROIC in detail.
Debt and equity are sources of finance which a business uses to invest in assets to generate economic benefits into the future. This is known as capital. However, not all the capital has been invested or used to purchase operating assets. Some of that capital is sitting idle i.e. not used as part of the operations of the business. Cash balance is a common example of idle capital.
Moreover, the net operating assets could be said to be invested capital. These are assets that are used in the business’s operations, less the liabilities used in the business’s operations. They include:
- Inventories, accounts receivable, less accounts payable etc. known as ‘operating working capital’
- Property, plant, and equipment
- Intangible assets needed by the business
- Any other operational assets less operational liabilities the business needs to operate
Another way of approaching the invested capital is to look at the amount of capital that investors have given to the business. We will end off with the same answer, so an example is the best way to illustrate this:
Invested capital is calculated by taking net debt plus the balance sheet value of shareholders’ equity. Capital employed is calculated by taking the assets used in the operations less the liabilities used in the operations.
Net operating profit after tax represents the after tax, but before financing cost/income generated by the investments made in the operations. NOPAT is the return generated by invested capital. We can better understand why we use the EBIAT figure by reviewing the balance sheet:
|Operating profit (EBIT)||Profits generated by the operational business|
|Interest income||Income generated by cash balances|
|Interest expense||Expenses generated by debt|
|Tax expense||Tax on all the above less the tax shield of interest|
Invested capital is before adding cash and subtracting debt, so we must compare it to earnings before any interest lines. However, investors can only extract earnings from a business after tax, so we compare the invested capital to after tax EBIT.
Now we can calculate the return on invested capital (ROIC):
The business has generated earnings before interest and taxes or EBIT of 150. This earnings figure has been generated through its investments in its net operational assets of 1,209. However, not all the 150 is available to investors as earnings can only be removed from the business after paying tax. We must adjust the EBIT figure for tax expense:
EBIAT = 150 * (1-20%) = 120
Then, the 120 earnings (available to both debt and equity holders) and is divided by the capital provided to generate the earnings:
ROIC = 150.0 / 1,209.0 = 9.9%
This tells us that for every 100 invested in the company’s operations, the investors should expect a return of 9.9.
We have also calculated the Return on Equity by taking the net income divided by shareholders’ equity on the balance sheet. We use the balance sheet number as that is the capital given to the business.
Interpreting Return On Invested Capital
The Return On Invested Capital, often shortened to ROIC is useful to make asset allocation decisions. Assuming different investment opportunities are the same risk, the corporation should always invest in the one which gives the highest ROIC.
Another approach is to compare the ROIC to the investment’s Weighted Average Cost of Capital (the WACC). If the actual return (the ROIC) is greater than the expected return (the WACC) then the investment should be made.