Investors can use various profitability ratios to evaluate whether they should invest in a company. Some of these ratios are basic and allow investors to determine whether the company is profitable. However, investors may also want to know the returns they will get on their invested amounts. For these calculations, investors may use the Return on Invested Capital (ROIC).
What is Return on Invested Capital?
Return on Invested Capital is a profitability ratio that represents the percentage return that companies earn from their invested capital. ROIC is a metric that allows investors to determine how efficiently a company allocates its resources to make profits. Investors can use ROIC to gauge how much they can earn for the amount of investment they make in the company.
How to calculate Return on Invested Capital?
Investors can use the following formula to calculate the Return on Invested Capital for a particular investment.
Return on Invested Capital (ROIC) = Net Operating Profit After Tax (NOPAT) / Invested Capital
For the above formula, investors must first determine how much return the company generates. It includes after-tax earnings but before interest payments. This amount is not available in the company’s financial statements. Therefore, investors will have to calculate it manually. The formula for NOPAT is as below.
NOPAT = Earnings Before Interest and Taxes (EBIT) x (1 – Tax Rate)
Most of the information for the above formula is available in a company’s Income Statement. Therefore, calculating NOPAT should be straightforward.
Next, they must determine the value of the invested capital. Invested capital represents the amount that investors have contributed to the company through the purchase of shares. There are various ways to calculate the invested capital for a company. Firstly, there is the following formula.
Invested Capital = Total Debt + Total Equity and Equivalent Equity Investments + Non-Operating Cash
However, investors may also use the following formula to calculate the invested capital.
Invested Capital = Net Working Capital + Net Fixed Assets + Net Intangible Assets
Example
A company, Green Co, has Earnings Before Interest and Tax of $100,000. Similarly, the tax rate prevalent for the company is 20%. The total invested capital of Green Co. is $400,000. Therefore, Green Co.’s Return on Invested Capital will be as follows.
Return on Invested Capital = Net Operating Profit After Tax (NOPAT) / Invested Capital
Return on Invested Capital = [$100,000 x (1 – 20%)] / $400,000
Return on Invested Capital = 0.2 or 20%
How does Return on Invested Capital work?
The Return on Invested Capital formula returns a percentage value. It provides a measure of a company’s performance, showing much return it generates for each dollar of invested capital. Unlike some other ratios, investors can use ROIC both on its own and comparatively. They may also use as a comparative tool with a company’s weighted average cost of capital.
Usually, the higher a company’s ROIC is, the more profitable and efficient it is. Similarly, companies with ROIC higher than their WACC maximize returns for the invested capital. Investors also prefer to invest in companies that have an ROIC of at least 2% or higher. Anything below that usually indicates an inefficient use of resources.
Conclusion
Return on Invested Capital is a measure of efficiency and profitability for companies. Investors use it to determine whether they should invest in a company or not. The ROIC formula requires investors to take the ratio between a company’s returns and its invested capital. Investors can use ROIC on its own or comparatively. They can also use it to compare a company’s ROIC with its WACC.
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