How to Calculate Return on Invested Capital

Return on Invested Capital (ROIC) is a financial metric that measures how efficiently a company allocates its capital to profitable investments. A higher ROIC suggests that a company is generating more profit for every dollar of capital invested. This measure is useful because it focuses on the returns from a company’s core operations, independent of how the business is financed. By examining operational profitability relative to the capital used, one can gain insight into the quality of a company’s business model.

The Return on Invested Capital Formula

The formula for ROIC is NOPAT / Invested Capital. The numerator, Net Operating Profit After Tax (NOPAT), represents a company’s potential cash earnings if it were financed entirely with equity and had no debt. This provides a view of operational profitability by removing the effects of interest payments. The denominator, Invested Capital, is the total money raised by the company from both debt and equity holders to fund its operations.

Calculating Net Operating Profit After Tax (NOPAT)

The formula for NOPAT is Operating Income x (1 – Tax Rate). This figure is not listed on a company’s income statement but can be calculated using available items. The first component, Operating Income, is found on the income statement as “Earnings Before Interest and Taxes” (EBIT). It represents a company’s profit before accounting for interest and income tax expenses.

Next, determine the company’s effective tax rate by dividing the “Income Tax Expense” by the “Pre-Tax Income,” both found on the income statement. For example, if a company has an income tax expense of $30 million and pre-tax income of $100 million, its effective tax rate is 30%.

With both Operating Income and the tax rate, you can calculate NOPAT. If a company has an Operating Income (EBIT) of $200 million and an effective tax rate of 25%, the NOPAT would be $150 million, as the calculation is $200 million multiplied by (1 – 0.25).

Calculating Invested Capital

There are two methods for calculating Invested Capital: the operating approach and the financing approach. Both methods should produce a similar result due to the principles of double-entry accounting, where a company’s assets must equal its liabilities plus equity.

The Operating Approach

The operating approach focuses on the assets side of the balance sheet. The formula is Invested Capital = Net Working Capital + Property, Plant, & Equipment (PP&E).

To use this formula, first calculate Net Working Capital (NWC) by subtracting current operating liabilities from current operating assets. Current operating assets include accounts receivable and inventory, while current operating liabilities include accounts payable; cash is excluded from this calculation. The second component, Property, Plant, & Equipment (PP&E), is the book value of a company’s long-term physical assets and is found on the balance sheet.

The Financing Approach

The financing approach looks at the liabilities and equity side of the balance sheet and is simpler to calculate. The formula is Invested Capital = Total Debt + Total Equity – Cash & Cash Equivalents. The components are found on the balance sheet. Total Debt includes both short-term and long-term obligations, and Total Equity represents the shareholders’ stake. Cash and cash equivalents are subtracted because this capital is not actively used in core operations.

Interpreting the ROIC Result

A standalone ROIC number has limited utility; its value is revealed through comparison against the company’s cost of capital, its industry peers, and its own historical performance. A primary comparison is the company’s Weighted Average Cost of Capital (WACC), which is the average rate of return a company must pay its investors. If a company’s ROIC is greater than its WACC, it is creating value. If the ROIC is less than the WACC, the company is destroying value because investment returns are not covering financing costs. A benchmark for strong performance is an ROIC at least two percentage points above the WACC.

It is also important to compare a company’s ROIC to its competitors. A “good” ROIC is relative and varies between sectors, as capital-intensive industries like manufacturing may have lower average ROICs than asset-light sectors like software. This comparison helps determine if a company has a competitive advantage.

Finally, examining a company’s ROIC over several years provides insight into performance trends. A rising ROIC suggests improving efficiency in capital allocation. A declining trend may indicate a weakening competitive position or less profitable investment decisions.