Return on Invested Capital (ROIC)

What is Return on Invested Capital (ROIC)?

Return on Invested Capital (ROIC) is a financial metric used to measure how efficient a business is in generating profits from its long-term capital investments net of taxes for each unit of capital invested. The calculation can help investors decide whether to invest in a stock or business.

ROIC measures how much profit a business generates from its invested capital. It measures a company's ability to maximize the amount of money it receives from its investments. This metric puts a dollar number on the efficiency of a business and makes it easy to compare it to other businesses or its own historical performance.

How to calculate Return on Invested Capital (ROIC)?

Return on Invested Capital (ROIC) is calculated as:

ROIC = (Net Income - Dividends) / (Average invested capital - Excess Cash)

where:

• Net Income is the net income after taxes
• Dividends is the amount of dividends paid out
• Average Invested Capital is the average capital used for investing, including interest-bearing liabilities such as debt
• Excess Cash is the amount of money held either in a company's accounts or invested in short-term, low-yielding investments

What does a high ROIC mean?

A high ROIC means the company is generating a lot of profits from the capital it is using. A high ROIC implies that the company is using its resources efficiently and is producing more profit than other competitors.

On the other hand, a low ROIC means the company is failing to generate adequate returns from its capital and could be a warning sign for investors.

ROIC vs ROI vs ROE vs ROA vs ROCE

There are several other widely used metrics that measure profitability in terms of capital and investments.

• ROIC (Return on Invested Capital) measures a company’s ability to generate profit from its capital investments.
• ROI (Return on Investment) measures the performance of a specific investment, such as a project or a new product.
• ROE (Return on Equity) measures a company’s ability to generate profits from its shareholders’ equity.
• ROA (Return on Assets) measures a company’s ability to generate profits from its total assets.
• ROCE (Return on Capital Employed) measures measures a company’s ability to generate profit from its total capital investment.

What are the limitations of the ROIC metric?

ROIC is a very useful metric, however it may not give the full picture when judging a company's efficiency.

For instance, ROIC is not sensitive to a company's cash position, which can create an inaccurate comparison between companies whose balance sheets may have unusual levels of cash. Companies with large cash positions will have a higher ROIC than a company with a smaller cash position, even if all other factors are equal.

Also, ROIC fails to take into account a company's short-term debt positions, which could greatly influence its short-term profitability.

When investing in stocks, it is important to consider a variety of financial metrics and not just rely on ROIC when making decisions.

Why is Return on Invested Capital important?

Return on Invested Capital (ROIC) is a key indicator of a company's financial performance since it measures how effective a business is at generating profits from its capital investments.

It is usually used by investors to compare businesses in the same sector, as companies within the same sector tend to have similar capital investments. This makes it easier to see if one company is performing better than the other.

ROIC is a valuable indicator of a business's risk and reward, since it takes into account debt, cash, and other investments that a company has made.

ROIC can be used as a comparison tool when evaluating stocks to determine which offers greater potential since it takes into account the level of risk that each company has undertaken.