Calculating Return on Invested Capital (ROIC)
The return on invested capital (ROIC) formula is one of the more advanced profitability ratios used in the financial analysis of a business. It is also one of the more overlooked but useful financial ratios for businesses and investors alike. In addition to the use of ROIC for business financial analysis, it can be used for valuation purposes by potential firm investors. The ROIC allows you to make better decisions about the business firm since it uses more specific information than the return on equity ratio.
What Is Return on Invested Capital (ROIC)?
A company's ROIC is the ratio of its earnings before any interest expense on debt or taxes to the sum of its debt financing and equity financing. Earnings before any interest expense on debt can be determined by analyzing the company's income statement. This element of the equation is also called net operating profit after tax (NOPAT).
The sum of debt and equity financing is known as the capital structure of the business. The capital structure of a business is the money that is used to finance its operations. Businesses use both debt and equity financing, which is invested capital also known as total operating capital. The amounts of debt and equity used by the firm can be determined by analyzing the business's balance sheet.
ROIC is used by a business's financial managers for the purpose of internal analysis. It is a financial ratio also used by potential investors in the business for purposes of valuation. For example, a common financial ratio, return on equity (ROE), is often used in both financial analysis and valuation.
If two businesses are found to have the same ROE, the ROIC allows you to dig deeper into the financial statements and determine possible differences between them.
Components of ROIC
There are two components that make up the equation used to calculate a business's ROIC.
Net Operating Profit After Taxes (NOPAT)
NOPAT is after-tax operating cash generated by a company and available for all investors—both shareholders and debtholders. For either financial analysis or valuation by investors, companies are often compared using their net income. Net income is the bottom line of the company's income statement. Net income is important, but it does not always reflect the true performance of a company's operations or the effectiveness of its managers. A better measure is NOPAT, which standardizes the measurement because it is the amount of profit a company generates if it has no debt and holds no financial assets.
You can more accurately compare two companies with differing amounts of debt and disparate asset bases by using NOPAT instead of net income.
NOPAT is a representation of the income a company would have if there were no taxes. It is a more exact statement of a company's profit because it goes the exact amount of operating cash generated. If you use earnings before interest and taxes (EBIT) instead, you get a skewed number for operating cash generated since EBIT is calculated on an accrual basis.
Invested capital is the investment made in a business firm during its life by shareholders and debtholders. The shareholders invest in the business's stock, while the debtholders invest in either its short- or long-term debt, including bonds.
Invested capital serves two purposes for the business: It finances its day-to-day operations, and also allows the business to undertake capital budgeting projects, including expansion and the purchase of major fixed assets.
How to Calculate ROIC
Here are the steps to use to calculate ROIC via an example. XYZ Corporation has $30,000 on its income statement as its EBIT and its marginal tax rate is 28%. The firm has $35,000 in short-term and long-term debt and $65,000 in equity financing. It has $1,000 in retained earnings, $2,000 from cash from financing, and $2,000 from cash from investing.
- Income statement: On the income statement for the firm, there should be a line item called Earnings Before Interest and Taxes (EBIT).
- Adjust EBIT: For use in the NOPAT formula, EBIT must be adjusted for taxes. You need to know the firm's marginal tax rate. The marginal tax rate is the tax rate the firm pays on its last dollar of income. Multiply the EBIT by [1 - marginal tax rate (t)]
- Formula for the ROIC numerator: NOPAT = EBIT (1-.t) where t = firm's marginal tax rate
- Calculation: NOPAT = EBIT (1-t) = $30,000 (1-.28) = $21,600
Calculating Invested Capital
- Balance sheet and statement of cash flows: To calculate the denominator of the ROIC equation, you need access to both the firm's balance sheet and statement of cash flows.
- Consider debt financing: Calculate the total amount of the firm's debt. This calculation will include current liabilities plus long-term debt from the balance sheet.
- Consider equity financing: Calculate the total amount of the firm's equity financing which will include the common stock and retained earnings accounts on the balance sheet.
- Consider cash flows: Add together cash flows from investing and cash flows from financing from the statement of cash flows.
- Formula for the ROIC denominator: Invested Capital = Current Liabilities + Long-Term Debt + Common Stock + Retained Earnings + Cash from financing + Cash from investing.
- Calculation: Invested Capital = $35,000 + $65,000 + $1,000 + $2,000 + $2,000 = $105,000
ROIC = NOPAT/Invested Capital = $21,600/$105,000 = .206 = 20.6%
What ROIC Means to Your Business
ROIC simply tells the financial manager of a business how well the firm is using its money to generate profit or returns.
ROIC gives the financial manager some insight into whether the firm is making profitable investments for the future. If not, then the firm can make the necessary adjustments.
Financial managers can look at investments earning the same ROE and through ROIC, make better decisions.
Another valuable metric with which ROIC can be compared is the firm's weighted average cost of capital (WACC). Since the WACC is the average after-tax cost of a firm's capital, it can be compared to ROIC. If the ROIC is greater than the WACC, then the financial manager knows that they are creating value in the business. If it is less, they are diminishing value with their investment choices and should adjust their parameters.
When making an investment in a business, whether as a principal of a small company or as a stockholder in an international corporation, investors want to be able to quantify the annual return on their investment to determine whether it is worth continuing to finance.