What ROIC tells you
Return on invested capital measures how much after-tax profit the operations of a business earn on the capital put into it. The numerator is net operating profit after tax (NOPAT): operating income, also called EBIT, reduced by tax at the rate you enter. Because it starts from profit before interest, NOPAT estimates what the operations would earn after tax if the business had no debt.
Invested capital is the money lenders and shareholders have provided to run the business. The cited source takes the book value of debt plus the book value of equity and subtracts cash. Others subtract only cash beyond what the business needs to operate.
A result of 10.0% means the business earned 10 of after-tax operating profit for every 100 of capital invested in it, on average, during the period. A negative result means an operating loss.
Reading a high or low result
What is normal varies by industry and business model, because some businesses need far more capital than others to produce the same profit.
- A higher ROIC can mean the operations earn more on each unit of capital, through better pricing, lower costs or less capital tied up in equipment, inventory and receivables.
- A lower ROIC can point to thin operating margins, or to capital that is not yet earning, such as a new facility that is still building up output.
Analysts often compare ROIC with the business’s cost of capital, the return its lenders and shareholders expect. A return above that cost suggests the business is creating value with the capital; a return below it suggests it is not. Trends over several periods usually say more than a single figure.
Definitions vary
ROIC has no single standard definition, so two published figures for the same business can differ. The main choices are:
- Tax rate: the effective rate the business actually paid, or a statutory rate.
- Cash: subtracting all cash, only excess cash, or none.
- Leases: whether lease obligations count as debt in invested capital.
- Balances: average or ending invested capital.
Compare ROIC figures only when you know they were built the same way, and state the definition you use.
What ROIC does not show
- It leaves financing out on purpose, so it does not show how much debt the business carries or whether it can pay its interest.
- It relies on book values. Older, heavily depreciated assets make invested capital look small and ROIC look high.
- A large investment adds to invested capital straight away but may take years to add to profit, so ROIC can dip during a period of growth.
Average vs ending balances
NOPAT is earned over the whole period, while invested capital is measured on a single date. Averaging the opening and closing balances matches a full period of profit with the capital in use across that period. If you enter only the closing figure, the calculator uses ending invested capital and says so in the result.
Common mistakes
- Starting from net income instead of operating income. Net income is after interest, so it mixes in the financing costs that ROIC is meant to leave out.
- Counting only shareholders’ equity as invested capital. NOPAT is profit available to lenders and shareholders, so the capital should include both.
- Changing the definition from one year to the next, for example subtracting cash in one year and not the next.
- Comparing your figure with a published ROIC without checking how it treats tax, cash and leases.
Related measures
Return on assets uses net income, which is after interest, and divides it by total assets. Return on equity looks only at the return to shareholders, so borrowing can raise it in a way ROIC does not show. Operating profit margin uses the same operating income but compares it with revenue, which shows the profit side of ROIC on its own.