Before giving a company their hard-earned money, investors want to feel confident that their money will be used wisely to generate returns. Generating these sureties can be difficult. After all, it’s not a line item on a standard financial statement. That’s why understanding how to calculate and assess ROIC is important for financial advisors and investors.
Return on invested capital (ROIC) helps reveal how a company is using capital provided by investors to generate more returns and grow the business. Put simply, ROIC analyzes how effectively a company is using funds to build the company and give stakeholders a return on investment.
It is a percentage or ratio that indicates how successfully a company is generating returns with the money it has raised from outside sources. Used in conjunction with other calculations, ROIC can give a more complete view of a company’s potential.
Companies may receive large amounts of funding from investors, especially when actively seeking capital. For this reason, comparing the amount of capital a company has received to its profitability is an important way to assess potential investments. A company may appear profitable when in fact it hasn’t used the capital it has received as efficiently as its competitors, making it a potentially unwise investment.
ROIC may be used by investment firms to help determine whether or not a company is a wise investment. If a company's ROIC is greater than 2%, it is considered to be creating value. The cost of the investment and the profits generated are the two key components needed to calculate returns. Returns are all earnings that have been earned after taxes but before interest has been paid. All current long-term liabilities due within the year are subtracted from the company's assets to determine the value of an investment. The profit is then divided by the investment cost.
ROIC is calculated by dividing net operating profit after tax (NOPAT) by invested capital. The formula can also be written as (net income - dividends) by (debt + equity).
There are multiple ways to calculate invested capital. One method is to deduct cash and non-interest-bearing current liabilities (NIBCL) from total assets, which includes tax liabilities and accounts due as long as they are not subject to interest or fees. You can also deduct non-operating assets, such as cash and cash equivalents, marketable securities, and assets from discontinued operations by adding the value of a company's equity to the value of its debt.
ROIC is an incredibly valuable metric, yet it’s not very popular. One reason for this is that ROIC can’t simply be pulled straight from the balance sheet like revenue or profit could. It is especially valuable for evaluating companies in industries with large startup or ongoing capital costs, such as oil or semiconductor chip companies. ROIC is the standard benchmark for measuring performance for industrial companies.
After it’s calculated, ROIC is compared to working asset cost of capital, or WACC. The company is creating value for investors if the final ROIC figure is larger than the working asset cost of capital. The WACC is the risk-adjusted minimum rate of return at which a corporation generates value for its investors.
Investors can evaluate a company’s ROIC trends to help predict its future trajectory. For example, a company may have a high ROIC, but if it’s been declining for a significant period of time it may be a cause for concern. The opposite is also true. A company may have a lower ROIC than its competitors, but if it has been significantly improving that could indicate an opportunity for an investor to get in early on the next big player in the field.
ROIC may take more work to calculate than some other metrics that are easily available, but it is highly reliable. Investors that understand ROIC are poised to make smarter decisions and find quality companies before others are aware of the potential.
The return on investment capital (ROIC) is a percentage or ratio that indicates how well a firm is earning returns on the capital it has raised from outside sources. Investors use this metric to determine how much potential a company has to generate returns, especially when evaluating companies that require large capital investments such as many industrial industries.
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