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Return on Invested Capital

 

Return on invested capital (ROIC) or also called return on capital is a financial ratio employed to measure nominal company’s return that is earned by capital invested in operating asset. Basically return on invested capital is a similar ratio to return on asset but is more detailed and more exact. 

 

This ratio is a ratio of a firm and calculation of it includes both debt and equity capital and also do not excludes interest for financial liabilities of the company. 

 

ROIC calculation (ROIC formula)


ROIC (Return on invested capital) = NOPAT / Invested capital


NOPAT = Operating income * (1 – Tax rate*) 


Formula to calculate invested capital:

 

Invested capital = Book value of debt + Book value of equity – Cash = Fixed assets + Current assets – Current non-financial liabilities – Cash = Fixed assets + Non-cash working capital


* Tax rate should be equal to the marginal corporate income tax rate in company’s area. (Taxes are adjusted because if return is compared to cost of capital, it includes after tax cost of debt.)

** Invested capital may be calculated using balance sheet data in two ways (look at the formula above) but the result should be equal in both variations. Cash in the formula should include all financial assets that aren’t used in company’s activity; for example, if company has some cash but it needs that cash for its retail business then this cash should be allocated to the working capital. Current non-financial liabilities are usually trade liabilities and other short-term liabilities that aren’t charged by interest. 

 

So why would be this ratio so significant? Well, if calculated correctly, this ratio is very important as well as return on equity because it shows what value can be created by company compared to its cost of capital. If company’s return on capital is lower than its cost of capital, that would mean that such business is not worth to be expanded. But if return on invested capital is much higher than cost of capital, then huge profits (and value) can be created by expansion. Of course, this works theoretically, but in practice everything is more difficult, because the business model should create the same return on new investments as was in the calculations which is not very probable under real market conditions. Basically, ROIC is valuable when the profitability of new projects sustains the same level as on previous activity of the company.

 

 






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