Return on Invested Capital (ROIC)
Return on Invested Capital (ROIC) is another popular metric that is used widely in financial analysis. The reason for its popularity is that like ROA, ROIC can be used by both equity and debt holders. Also, like ROA, it provides data about return to the company as a whole and is not affected by leverage. Here is more about Return on Invested Capital;
Formula
The formula for calculating ROIC is as follows:
Return on Invested Capital = EBIT / Invested Capital
- Deriving Invested Capital: Note that Invested Capital is not the same as Capital listed on the balance sheet. Neither is it the balance sheet total. Invested Capital is a term analysts have coined in the recent past to denote capital that has been listed for the long term in the company’s operations.
Invested capital is derived by starting from the Balance Sheet Liabilities total and then subtracting the current liabilities from it. This is because current liabilities are not sustainable sources of long term financing and therefore cannot qualify as capital.
Meaning
The Return on Invested Capital (ROIC) metric measures the company’s efficiency at allocating its resources to generate the maximum return. Thus ROIC shows the relationship between invested capital and return. It must be thought about as having Rs X in earnings for every rupee in invested capital.
Assumptions
- Tax Planning not Considered: The Return on Invested Capital (ROIC) used EBIT which is a pre-tax figure. This ratio does not consider that companies can make significant differences to their profitability with the help of tax planning strategies. Some analysts use both pre-tax and post-tax ROIC numbers to get a better picture of the company’s operations.
- Accurate Book Values: The Return on Invested Capital (ROIC) assumes that the book values stated are accurate. In many cases, the book values and the market values of assets are very different. One such example is land. Thus, ROIC becomes a misleading figure. This is because many times analysts consider the opportunity cost based on market value and the ROIC drops drastically.
Interpretation
No Break-Up Provided: ROIC does not provide break up about whether income has been earned from regular operations or from one time activities.
Used to Evaluate Acquisitions: Return on Invested Capital (ROIC) is useful in case of companies that have done many acquisitions. Since it is difficult to segregate the cash flows of the two merged companies, ROIC with and without the acquisition serves as a measure of gauging success.
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