What is the Return on Invested Capital (ROIC) Ratio?
The Return on Invested Capital (ROIC) is a profitability metric that measures the total return a company generates on the capital invested by both debt holders and equity shareholders. It evaluates how effectively a company uses its invested capital to generate profits.
ROIC provides insights into a company’s ability to create value, where a higher ROIC indicates efficient use of capital to generate returns above the cost of capital. It is especially important for investors and stakeholders to determine if the company is using its resources effectively to generate sustainable growth.
Table of Contents
- What is the Return on Invested Capital (ROIC) Ratio?
- Why Do Companies Calculate the Return on Invested Capital (ROIC) Ratio?
- How to Calculate the Return on Invested Capital (ROIC) Ratio
- How Does the ROIC Ratio Work?
- Business Scenario Example
- How to Improve Return on Invested Capital?
- Example of ROIC: Comparing Two Companies
- Benefits of Return on Invested Capital (ROIC) Ratio
- Limitations of Return on Invested Capital (ROIC) Ratio
- Conclusion
- Pro Tip
Why Do Companies Calculate the Return on Invested Capital (ROIC) Ratio?
- Measure Value Creation:
- ROIC determines whether a company is generating returns above its cost of capital. If ROIC exceeds the cost of capital, the company is creating value for shareholders.
- Assess Operational Efficiency:
- It evaluates how efficiently management is utilizing both equity and debt to produce profits.
- Attract Investors:
- A high ROIC indicates strong performance, attracting potential investors seeking companies that maximize returns.
- Benchmark Against Competitors:
- ROIC allows companies to compare their profitability and efficiency relative to industry peers.
- Strategic Decision-Making:
- ROIC helps management decide where to allocate capital and whether to pursue certain investments or projects.
How to Calculate the Return on Invested Capital (ROIC) Ratio
The formula for the Return on Invested Capital (ROIC) Ratio
Where:
- EBIT (1 – T): The after-tax operating income or Net Operating Profit After Taxes (NOPAT). It is calculated as:
- Debt: The total interest-bearing debt of the company.
- Equity: The shareholders’ equity, including retained earnings.
- Debt + Equity: Represents the total invested capital.
How Does the ROIC Ratio Work?
- High ROIC:
- A high ROIC (above the company’s cost of capital) indicates the company is efficiently utilizing its invested capital to generate strong returns.
- For example, a company with a ROIC of 15% and a cost of capital of 10% creates 5% of value for every dollar invested.
- Low ROIC:
- A low ROIC (below the cost of capital) suggests inefficient use of resources, potentially destroying shareholder value.
- For example, a company with a ROIC of 8% and a cost of capital of 10% destroys 2% of value for every dollar invested.
Business Scenario Example
Scenario:
Let’s analyze Allied Industries, a manufacturing company.
- EBIT = $283.8 million
- Tax Rate = 40%
- Debt = $860 million
- Equity = $940 million
- Total Invested Capital = Debt + Equity = $1,800 million
- Industry Average ROIC = 10.8%
Calculation:
1. Calculate NOPAT:
2. Calculate ROIC:
Interpretation:
- Allied’s ROIC:
- Allied’s ROIC is 9.5%, meaning the company generates $0.095 in after-tax operating income for every $1 of invested capital.
- Comparison to Industry Average:
- The industry average is 10.8%, so Allied’s ROIC is below average. This indicates that Allied is less efficient at generating returns on its invested capital compared to its peers.
- Impact on Value Creation:
- If Allied’s cost of capital is higher than its ROIC (e.g., cost of capital = 11%), the company is destroying value for its investors. However, if the cost of capital is below 9.5%, Allied is still creating value, albeit less efficiently than its competitors.
- Challenges:
- Allied’s lower ROIC could result from:
- High operating expenses: Reducing EBIT.
- Inefficient asset utilization: Assets not generating sufficient returns.
- High-interest expenses: From significant debt levels.
- Allied’s lower ROIC could result from:
How to Improve Return on Invested Capital?
- Increase NOPAT:
- Improve revenue through higher sales or pricing strategies.
- Reduce operating expenses and streamline processes.
- Optimize Capital Allocation:
- Focus on high-return investments and divest underperforming assets.
- Avoid overinvestment in low-yield projects.
- Reduce Debt Levels:
- Lower interest expenses by paying off debt or refinancing at lower rates.
- Improve Asset Utilization:
- Use existing assets more effectively to increase profitability.
Example of ROIC: Comparing Two Companies
Company A:
- EBIT (1 – T): $200 million
- Debt + Equity: $1,000 million
Company B:
- EBIT (1 – T): $100 million
- Debt + Equity: $1,000 million
Analysis:
- Company A: Generates a higher ROIC of 20%, indicating better efficiency in using invested capital.
- Company B: ROIC of 10% is lower, suggesting weaker performance relative to Company A.
Benefits of Return on Invested Capital (ROIC) Ratio
- Focus on Core Operations:
- Highlights operational efficiency and profitability from invested capital.
- Value-Creation Indicator:
- Determines if the company is generating returns above its cost of capital.
- Comparison Across Industries:
- Useful for evaluating companies within and across industries with varying capital structures.
- Decision-Making Tool:
- Guides management on capital allocation and investment decisions.
Limitations of Return on Invested Capital (ROIC) Ratio
- Ignores Intangible Assets:
- ROIC may undervalue companies with significant intangible assets, like tech or software firms.
- Short-Term Focus:
- The ratio focuses on current performance and may not reflect long-term growth potential.
- Varies Across Industries:
- Capital-intensive industries (e.g., manufacturing) tend to have lower ROIC compared to asset-light industries (e.g., technology).
Conclusion
The Return on Invested Capital (ROIC) ratio is a critical metric for assessing a company’s ability to generate profits from its total invested capital. By comparing after-tax operating income to invested capital, ROIC provides valuable insights into operational efficiency and value creation.
For companies like Allied Industries, an ROIC of 9.5% highlights the need to improve operational efficiency and optimize capital allocation to compete with industry leaders. Monitoring and improving ROIC ensures better decision-making, enhanced shareholder value, and sustainable growth.
Pro Tip
To fully understand a company’s performance, always compare ROIC with the company’s cost of capital and evaluate it alongside other metrics like ROA, ROE, and profit margins.
