What Does Return on Invested Capital (ROIC) Mean?
Return on invested capital (ROIC) is a metric used to determine the amount of money that a company generates from the capital invested within it. Though a company should earn money from every dollar that is invested in it, this is not always the case due to internal factors, external factors or a combination of both.
Divestopedia Explains Return on Invested Capital (ROIC)
A company earns ROIC when its profits are higher than the cost of capital, also known as weighted average cost of capital (WACC). In this case, the company is generating more value for its investors. On the other hand, when its WACC is more than its ROIC, then the company is taking a loss and, thus, diminishing value for the investors.
There are two accepted ways of calculating ROIC. The first is as follows:
ROIC = NOPLAT / (Working Capital + Fixed Assets)
NOPLAT (net operating profits less adjusted taxes) represents the profits earned by the company from its core operations. It is often computed by subtracting the relevant income tax on the income earned by the company to give a more accurate picture of a company's revenue. This measure is an important one in discounted cash flow (DCF) methods as well as for ROIC.
The second formula used to compute ROIC is:
ROIC = (EBIT*(1-T)) / (Working Capital + Fixed Assets)
In this formula, EBIT (earnings before interest and taxes) is computed by subtracting operating expenses and non-operating revenue from operating revenue. This value gives a measure of the company's earnings without taking into account its interest obligations and taxes. Finally, T stands for taxes.
Both of the above formulas lead to the same value, but the choice depends on what information is available about a firm. In general, EBIT is more easily available when compared to NOPLAT and this is why the latter formula is more often used.
Other than the above two formulas, some organizations prefer to calculate ROIC as:
ROIC = (Net Income - Dividends) / (Debt + Equity)
Finally, it may also help the company to ascertain how much it earns on every invested dollar so that appropriate changes can be made to operations and strategy.