Return on Invested Capital (ROIC)

ROIC means Return on Invested Capital and it is a profitability ratio which aims at measuring the return (expressed in percentage) that investors of a company earn from the capital that they have invested. The ratio shows that how efficiently a company is using the funds of the investors to generate income. Hence, the amount of long-term debt, amount of common shares and preferred shares forms the components of invested capital. ROIC is also known as “Return on Capital” or “Return on Total Capital.”

How to Calculate ROIC

The formula for Return on Invested Capital is as follows:

ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital

NOPAT – It is the operating profit (mentioned in the income statement) from which taxes are subtracted. The interest expense has not been taken out of this equation, hence, NOPAT = EBIT*(1-tax rate).

Invested Capital – It is the total amount of long term debt plus the total amount of equity. The last part of invested capital is to subtract the amount of cash that the company has on hand. Invested Capital = Fixed Assets + Intangible Assets + Current Assets – Current Liabilities – Cash.

How ROIC is useful

Returns on Invested Capital differs from business to business. Thus, investors can use ROIC to benchmark the relative attractiveness of an industry or they can also use it to compare companies within the same industry to find the most attractive company to invest into.

Furthermore, the Return on Invested Capital tells that how well a company is performing and how much cost, the company is incurring in order to obtain the capital which it uses to invest in the business. If the ROIC is higher than the cost of capital (COC), then we can say that the business is healthy and doing well. If ROIC is lower than the cost of capital (COC), then we can say that the business is unsustainable, even if the ROIC is higher in absolute terms. Return on invested capital indicates how profitable and sustainable a business is.

Let’s understand ROIC in a better way with the help of the following example.

Marie owns ABC Inc. which specializes in agricultural and construction equipment. Marie wants to find out that how ABC Inc, has been performing and then she looks at the returns of the company by doing analysis of the capital invested but there has not been any record of the return on invested capital ratio kept by the company. Marie did the ROIC analysis and the information is as follows:

Long-term debt – $35 million

Shareholder’s Equity – $85 million

Operating Profit – $10 million

Tax Rate – 35%

WACC – 3%

Now, by putting the values in the formula Marie found the following:

$10 million – (10 million * 35%) = $6.5 million

$6.5 million/ ($35 million + $85 million) = 5.41666667% = ROIC

To see how well the company is actually generating a return, Marie then compares the 5.41666667% to the WACC which is 3%. Hence, there is an increase in 2.41666667% profits than the cost of keeping the operations going.

The general equation for ROIC is: (Net income – Dividends) / (Debt + Equity)

Return on Capital Employed (ROCE)

ROCE means Return on Capital Employed and it is a financial ratio which measures the profitability and efficiency of a company with which its capital is employed. It measures the returns (expressed in percentage) that a business achieves from the capital employed. Thus, we can say that Capital Employed is the addition of company’s Equity and Non-current liabilities or Total Assets less Current Liabilities.

A good ROCE means the rate at which the company generally borrows. In case, ROCE is lesser than the rate of borrowing then any increase in borrowing will result in decreased earnings of the shareholders and vice versa.

How to Calculate ROCE

The formula for Return on Invested Capital is as follows:

ROCE = EBIT / Capital Employed = EBIT / (Equity + Non-current Liabilities) = EBIT / (Total Assets – Current Liabilities)

How ROCE is useful

ROCE is useful while comparing the performance of different companies that are in capital-intensive sectors such as utilities and telecoms. The reason behind this is, ROCE considers debt and other liabilities also. This indicates a better financial performance for those companies which have significant debt.

Adjustments are needed to be done in order to arrive at a true ROCE. The trend of ROCE over the years is also an important indicator of a company’s performance. Investors trust those companies which have stable and growing ROCE over those companies whose ROCE is volatile.

Let’s understand ROCE in a better way with the help of the following example

Suppose there are two companies, X and Y, X has a profit margin of 20% and Y has a profit margin of 25%. Here, Y is performing better. Company Y would be called a less financially stable company, if it would use twice of its capital in order to generate the profit since it is not utilizing its maximum revenues. Higher value of the company (in percentage) means higher ROCE and further it can be distributed as profit to the shareholders. Therefore, in in order to conclude on this, ROCE should be equal to at least twice current interest rates.

Difference between ROIC and ROCE

Conclusion

ROIC and ROCE are both very important ratios that shows comparisons between companies and past year ratios. ROIC measures the efficiency of total capital invested, while ROCE measures the efficiency of business operations. They are much suited for companies in capital-intensive industries such as telecommunication, energy and automotive. These measures have limited use in service related companies.

Author: Ritu J. – Jr. Analyst

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