# Return on Invested Capital (ROIC)

ROIC measures a company's efficiency in allocating capital to profitable investments, using NOPAT/invested capital.
Return on Invested Capital (ROIC)
3 min
03-July-2024

ROIC is a popular profitability ratio. It helps investors measure how well a company is using its invested capital to generate profits.

If you are a stock investor who wants to invest in a company's stock, you must know how the company utilises raised capital from investors. This will help you assess the fundamentals of the company. By knowing this, you can decide whether to invest in the company stock or not.

Understanding a company's financial performance is crucial for investors and stakeholders, and one key metric to consider is Return on Invested Capital (ROIC). In this article, we will dive into the concept of ROIC, a measure that helps determine how efficiently a company is using its capital to generate profits. We'll explore what ROIC is, why it's important, and how it differs from other financial metrics. Additionally, we'll provide a step-by-step guide on how to calculate ROIC, including the necessary components and formula. By the end of this article, you'll have a comprehensive understanding of ROIC and how to use it to assess a company's financial health.

## What is Return on Invested Capital (ROIC)?

The full form of ROIC is the return on invested capital. When a company raises funds by issuing its shares or bonds, it is called invested capital. ROIC provides you with an idea of how efficiently a company is using this invested capital. ROIC helps you know how much money the company makes or generates a profit compared to how much it receives from shareholders or bondholders.

## How to calculate ROIC?

### ROIC formula

You can calculate ROIC with this formula:

ROIC = (Net operating profit after tax) / (Average capital invested)

According to this formula, the return on invested capital is equal to the ratio of NOPAT (net operating profit after tax) to average invested capital. What are the different components of this formula? Let us understand them better:

• NOPAT is the company's operating profit after tax. This means it represents the profit available for all the investors who invested in the company.
• Invested capital is the capital the company has raised by selling its shares or issuing debt bonds.

This ratio helps you get a percentage value that tells you how much profit a company can generate with every invested rupee. If the value of ROIC is high, especially above 2%, then the company can be considered highly efficient in using shareholders’ or investors’ capital. When you are planning to invest in a company’s stock, check its ROIC. If it is consistently high, you can expect to get good returns in the long run.

## What are the steps to calculate ROIC?

There are 3 steps for computing return on invested capital. These steps are outlined below:

### Step #1: Calculate the value of NOPAT

You can find the NOPAT value with the help of any of the following two formulae:

Simplified formula of NOPAT = Operating profit x (1 – effective tax rate)

Complex formula of NOPAT = (Net income + non-operating income loss – non-operating income gain + interest expense + tax expense) x (1 – effective tax rate)

### Step #2: Compute the value of average invested capital

You can compute the average invested capital by adding fixed assets with net working capital and acquired tangibles (which include goodwill).

Its formula is:

Average invested capital = (Invested capital in the beginning) + (Average incremental non-acquired invested capital) + (Adjusted total acquired invested capital)

Invested capital is the capital that was invested when the company started.

Average incremental non-acquired invested capital is the total average value of new capital that has been invested in the company. However, it does not include any capital if there is any acquisition.

You can calculate it using the following formula:

[(Ending invested capital) - (Beginning invested capital) - (Acquired invested capital)] / 2

Adjusted total acquired invested capital is the capital invested as part of any acquisition. This is nothing but invested capital’s time-weighted value.

You can calculate it with the following formula:

(Acquired capital’s value) x (Percentage of the year that the company employed that invested capital)

Average invested capital = Invested capital in the beginning + [{(Ending invested capital) - (Beginning invested capital) - (Acquired invested capital)} / 2] + [(Acquired capital’s value) x (Percentage of the year that the company employed that invested capital)]

### Step #3: Division of NOPAT by average invested capital

Once you have calculated the values of both NOPAT and average invested capital, you simply have to divide net operating profit after tax by average invested capital.

Also read: What are sinking funds?

## Example of return on invested capital

Now that the meaning and calculation of return on invested capital are clear, let us better illustrate the concept with an example. Let us assume that a business ‘G’ has generated Rs. 80 crore worth of NOPAT in year one. In addition, it has an average investment value of Rs. 800 crore in the same period. Thus:

• NOPAT = Rs. 80 crore
• Average invested capital (IC) = Rs. 800 crore

Now, taking into consideration the values of NOPAT and IC, the return on invested capital can be calculated as 10%.

ROIC = Rs. 80 crore ÷ Rs. 800 crore = 10%

In this example, the 10% ROIC of company G indicates that it has generated Rs. 10 in net earnings per Rs. 100 invested.

## Drawbacks of ROIC

Despite the crucial importance and relevance of ROIC for company investments, the metric does have certain limitations and drawbacks that necessitate further enquiry. Some of its drawbacks are discussed below:

### Multiple segments

Numerous companies operate in more than one sector or segment. Some may be capital-intensive, while others may not be. As the ROIC metric takes into account the entire company’s operations, it is often difficult to objectively assess whether all the segments are generating strong returns or if the returns are unevenly distributed.

### Industry applicability

ROIC is less applicable to a few industries, such as financial companies, where capital is used in the companies’ products.

### Vulnerability to factors that generate misleading ROIC

• Goodwill
Companies with significant goodwill on their balance sheets will show lower ROIC because of a high denominator. If goodwill is written down, adjustments must be made for a ROIC historical analysis.
• Capital leases and excess cash
Comparisons in ROIC can be skewed if one company has more capital leases than the other. Thus, for a true comparison, modifications need to be made in the calculation. Excess cash can deflate ROIC and should be subtracted from the net working capital for accurate analysis.

### Non-recurring events

Significantly big one-time profits or losses can also distort ROIC. These should be excluded when evaluating normal business operations. To account for big changes, be mindful of variations and anomalies in income statements and balance sheets when undertaking ROIC analysis of multiple competing businesses.

Also read: What is a family of funds?

## Why ROIC matters for investment?

By now, it must be clear that ROIC can be an insightful metric for businesses and investors. For businesses, it can help them understand the efficiency of their investments and make changes wherever necessary. And for investors, it is an insight into the operational and financial health of a business. Let us now take a look at a few prominent ways in which ROIC has carved out its importance for investments:

### Indicator of success for both parties

ROIC can be utilised to monitor your success if you run a business or you are planning to invest in a business. For example, as an investor, you can assess the ROIC data to understand how your invested business has performed and make strategic investment decisions based on the insights. Similarly, as a business owner, you can utilise the ROIC information to ensure that investor money is being used efficiently to generate more wealth. This also has the benefit of reassuring investors that your business is continually growing and is worth investing in.

### Finding optimal investment options

ROIC is a helpful metric in searching for the most optimal investment options. It can help you discover strong performers among various companies. Businesses are always looking for more investors for multiple reasons. ROIC is immensely helpful for investors in sorting companies, comparing them, undertaking historical analysis, and figuring out investment strategies accordingly. For instance, as an investor, you can seek details about a company’s historical earnings and undertake a pro and con analysis to make an informed investment decision.

For businesses, ROIC can help them stand out from the crowd. It is a great way to project the company’s success and earnings along with similar data to show their potential and secure higher investments.

### Make better decisions

ROIC is an indicator of success for both the business and the investors. It reassures both sides; investors can know if they want to continue their investment or find other avenues, and businesses can continuously optimise their investment choices. ROIC empowers both sides to clearly understand and protect their returns and measure success to maintain a cordial business relationship without hassle.

Also read: How does fund of funds work?

## Conclusion

An ROIC above 2% is considered a good return on invested capital. If you are an investor, you should first use the ROIC formula to know the ROIC ratio. If it is more than 2%, it means that the business in which you have invested your capital is employing the capital productively and profitably. If the ratio is less than 2%, it means the company is not using the invested capital efficiently.

Do you want to invest in stocks? If you are a newbie, you may start by investing in mutual funds. You can begin your investment journey by exploring the Bajaj Finserv Mutual Fund Platform, as 1000+ mutual fund schemes are listed on the platform. You can easily compare mutual funds and make well-informed investment decisions. You can also use the SIP calculator and lumpsum calculator to predict returns and create an optimal investment plan.

## Essential tools for mutual fund investors

Is return on capital the same as ROIC?

Yes, the return on capital (ROC) is the same as ROIC (return on invested capital).

What is a good ROIC ratio?

If the ROIC ratio of a company is more than 2%, it is considered a good one because it is considered to be creating value. If the ROIC ratio is less than 2%, the company is considered to be destroying value.

Is ROIC better than ROCE?

Both ROIC and ROCE are profitability ratios. Both of them help you understand how efficiently a company is using its capital to generate profits. Whether one is better than the other depends on who is using the metric and its use. The ROIC metric is better for investors to understand how good their invested capital is being used by the company which they have invested. ROEC, on the other hand, is more useful to companies to compare different tax systems and companies in different countries.

Is a 50% ROIC good?

If a company has a 50% ROIC, it is very good. It opens up possibilities for a company to grow at the extent of 50% every year. The company can reinvest all its earnings and consequently grow at 50% per annum without having to borrow any money.

What are the limitations of ROIC?

One limitation of the ROIC metric is that it does not tell you about the exact segment of the company that is generating the value.

What is the ROIC formula?

The ROIC formula is equal to NOPAT /Invested capital. Here, the full form of NOPAT is Net Operating Profits After Tax. The formula to calculate NOPAT is equal to (Operating income) x (1 – tax rate).

How do you interpret the ROIC ratio?

ROIC ratio is expressed as a percentage value. If the ROIC of a company is more than its WACC (Weighted Average Cost Of Capital), the business is considered to generate value for the investors who have invested in it.

What is the return on investment capital?

The return on investment capital measures the percentage return a company earns from investment capital. It helps in the determination of a company’s capital allocation to investments or projects that are profitable.

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