How to Calculate the Return on Invested Capital (ROIC)?
Before learning how to calculate the ROIC, let’s first understand what Invested Capital is. Invested capital is the total capital that is invested in a business and includes both equity and debt. Equity refers to the amount of capital invested by shareholders while debt refers to the money borrowed from lenders to finance operations.
Formula for Calculating ROIC:
The formula to calculate ROIC is as follows:
ROIC = Net Operating Profit after Tax (NOPAT) / Invested Capital
Where:
- NOPAT: Net Operating Profit after Tax refers to the total operating profit of a company after deducting all taxes. It is calculated as Operating Profit * (1 – Tax Rate).
- Invested Capital: It is the total amount of capital invested by both equity holders and debtholders in a company.
Explanation of the Formula:
The ROIC formula calculates the rate of return a company generates from the capital invested in its business operations. NOPAT is the company’s earning after deducting operating expenses and taxes. Invested Capital is the total amount of equity and debt invested in a company. The ROIC formula calculates the profitability of the invested capital during a specific period.
Example Calculation:
Let’s take an example to understand the ROIC calculation.
NOPAT = 200,000 Invested Capital = 1,000,000 ROIC = 200,000 / 1,000,000 ROIC = 0.20 or 20%
The ROIC of the company is 20%, indicating that for every dollar invested in the business, 20 cents of profit is generated.
Valuation and Interpretation:
ROIC is a significant measure to evaluate a company’s ability to use its invested capital efficiently. A high ROIC value indicates that the company is efficient in using its capital to generate income. Additionally, a company with a higher ROIC is considered to be financially sound and profitable, making it an attractive investment option. However, the interpretation of ROIC depends on the industry and the company’s growth prospects. For instance, if the company operates in an industry with lower growth prospects, a lower ROIC may still be considered good. Similarly, a high ROIC in a high-growth industry may not necessarily be good.
Benefits of Calculating ROIC:
1. Better Investment Decisions:
The ROIC metric helps investors make better investment decisions by enabling them to evaluate how effectively a company is using its capital to generate profits. A higher ROIC indicates that a company is utilizing its invested capital efficiently, making it an attractive investment option.
2. Comparative Analysis:
ROIC also aids in comparative analysis between companies in the same industry. Investors can compare the ROIC of different companies to determine which companies are generating higher returns from their invested capital, making them more profitable.
3. Financial Health:
ROIC can provide insights into the financial health of a company by indicating how efficiently it is utilizing its invested capital to generate profits. A higher ROIC suggests that the company is financially strong and generating profits effectively.
4. Capital Allocation:
ROIC is also handy in the allocation of capital. A company with higher ROIC can reinvest its profits into the business to achieve higher profitability and growth. Similarly, a company having a lower ROIC can reevaluate its investment strategies and redeploy its resources to achieve optimal returns.
By Astrobulls research pvt ltd