How to Find Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a financial metric that shows how effectively a company uses its capital to generate profits. It indicates how well management allocates and employs capital to produce returns. For investors, understanding ROIC helps assess a company’s financial health and operational efficiency.

Understanding the Core Components of ROIC

The calculation of Return on Invested Capital (ROIC) relies on two primary financial components: Net Operating Profit After Tax (NOPAT) and Invested Capital. NOPAT focuses on profitability from core operations, while Invested Capital quantifies the total capital used to achieve that profit.

Net Operating Profit After Tax (NOPAT) represents the profit a company earns from its ordinary business activities after taxes, but before interest expenses. This metric provides a clear view of a company’s operating efficiency, free from the influence of its capital structure.

Invested Capital represents the total money a company has deployed to fund its operations. This includes both debt and equity financing, signifying the entire pool of capital available to generate returns.

Calculating Net Operating Profit After Tax (NOPAT)

Calculating Net Operating Profit After Tax (NOPAT) begins with a company’s Operating Income, also known as Earnings Before Interest and Taxes (EBIT), found on its income statement. This figure reflects profits generated purely from primary business operations.

To arrive at NOPAT, Operating Income must be adjusted for taxes. The formula is NOPAT = Operating Income (1 – Tax Rate). The tax rate should be the company’s effective tax rate, which is the actual rate of tax paid on its taxable income.

For example, if a company reports an Operating Income of $1,000,000 and has an effective tax rate of 25%, the NOPAT would be $1,000,000 (1 – 0.25) = $750,000. This represents the profit from core operations available to all capital providers after corporate taxes.

Calculating Invested Capital

Invested Capital represents the total capital a company has deployed to generate its operating profits, encompassing both debt and equity. A common approach is to sum total debt and shareholders’ equity from the balance sheet. Total debt typically includes both short-term and long-term debt, found under the liabilities section.

After summing total debt and shareholders’ equity, certain adjustments are often made to refine the figure. A primary adjustment involves subtracting non-operating cash and cash equivalents, which are funds not directly used in day-to-day operations. This adjustment ensures the calculation isolates capital directly contributing to operational earnings. For instance, if a company’s balance sheet shows total debt of $500,000, shareholders’ equity of $1,500,000, and non-operating cash of $100,000, the invested capital would be $500,000 + $1,500,000 – $100,000 = $1,900,000.

The ROIC Formula and a Step-by-Step Example

The Return on Invested Capital (ROIC) formula is ROIC = NOPAT / Invested Capital. This ratio shows how much profit a company generates for each dollar of capital it employs. A higher ROIC suggests more efficient capital deployment.

To illustrate, consider “Alpha Corp.” First, determine Alpha Corp.’s Net Operating Profit After Tax (NOPAT). If Operating Income (EBIT) is $2,000,000 and the effective tax rate is 20%, NOPAT = $2,000,000 (1 – 0.20) = $1,600,000.

Next, calculate Alpha Corp.’s Invested Capital. If total debt is $3,000,000, shareholders’ equity is $7,000,000, and non-operating cash is $500,000, Invested Capital = $3,000,000 + $7,000,000 – $500,000 = $9,500,000.

Finally, calculate ROIC: $1,600,000 (NOPAT) / $9,500,000 (Invested Capital) = 0.1684 or 16.84%. This means for every dollar of capital invested, Alpha Corp. generated approximately 16.84 cents in after-tax operating profit.

Interpreting and Applying Your ROIC Calculation

A high ROIC indicates a company effectively generates profits from its invested capital, suggesting strong management and a business model capable of creating value. Conversely, a low ROIC may signal inefficiencies or operational challenges.

ROIC should not be viewed in isolation. Its true value emerges when compared against relevant benchmarks. One crucial comparison is against the company’s cost of capital, which represents the average rate of return a company must pay to its providers of capital (both debt and equity). If a company’s ROIC is consistently higher than its cost of capital, it suggests the company is creating value for its shareholders.

Further insights come from comparing current ROIC to historical performance. An increasing trend may indicate improving operational efficiency, while a declining trend could signal deteriorating performance. Additionally, comparing ROIC to industry peers provides context on competitive standing. A company with a higher ROIC than competitors often demonstrates a competitive advantage in deploying capital.