ROIC is the Return On Invested Capital and, simply put, indicates how well a company is using it’s capital. As such, this is a very powerful indicator and forecasting tool for the current and future profitability of a company. However, because of it’s relative complexity, it is often overlooked in favor of simpler metrics.
If you’re not familiar with Financial Analysis, ROIC can be pretty daunting. Even so, I will try to go slowly, and explain each step along the way.
I will first explain how to calculate ROIC. Then I will provide an example, and how ROIC can be used in Financial Analysis.
Calculating ROIC
Calculating ROIC is somewhat complicated. ROIC is the quotient of two other financial calculations:
- NOPAT – Net Operating Profits After Taxes.
- Working Capital – the cash required to sustain daily operations.
ROIC is thus calculated as:
ROIC = NOPAT / Working Capital
Calculating NOPAT
NOPAT is calculated as:
NOPAT = Operating Income * (1 – Tax Rate)
NOTE: ‘Operating Income’ may also be listed as Earnings Before Interest and Taxes (EBIT)
For example: If a company had an Operating Income of $20,000 and a tax rate of 20% then the NOPAT would be calculated as:
NOPAT = 20,000 * (1 – 0.25) = $15,000
Determining Working Capital
Working Capital is calculated as:
Working Capital = Current Assets – Current Liabilities
For example: If a company has $150,000 in Current Assets and $79,000 in Current Liabilities, then the Working Capital would be calculated as:
Working Capital =$150,000 – $79,000 = $71,000
But what are Current Assets and Current Liabilities?
Current Assets
Broadly speaking, Current Assets are any assets which you expect to be liquidated into cash, through standard business operations, by the end of the year. This includes things such as:
- Cash
- Accounts Receivable
- Inventory
- Prepaid Expenses
- Marketable Securities
Adding all of the current asset amounts results in the Current Assets value that you will use in determining Working Capital.
Current Liabilities
Similarly, Current Liabilities are any debts or obligations that the company is expected to pay, through standard operations, by the end of the years. This includes things such as:
- Accounts Payable
- Taxes Payable
- Short-term Debt
Adding all of the current liabilities amounts results in the Current Liabilities value that you will use in determining Working Capital.
ROIC
So in our example above, we have:
- NOPAT = $15,000
- Working Capital = $71,000
So our example ROIC can be calculated as:
ROIC = 15,000 / 71,000 = 0.211 or 21.1%
Analyzing ROIC
So is a ROIC of 21.1% good? Actually, ROIC by itself doesn’t tell us a whole lot. What we want to do is compare a company’s ROIC against their Weighted Average Cost of Capital (which I’ve written about here).
If ROIC is greater than WACC then you may infer that the company is using it’s capital efficiently.
If ROIC is less than WACC then you may infer that the company is not using it’s capital efficiently.
The Good News
I know that this seems like a lot of work. The good news is that you can find the ROIC and the WACC for a company pretty easily. Sites like GuruFocus.com (no affiliation with this site) can help you find and compare ROIC and WACC information relatively quickly.
So why learn how to do it by hand?
I strongly advocate that you, as an investor, understand how to find these numbers by hand. It will help you gain first-hand knowledge of what these measures mean and how to best interpret them.
Knowing that ROIC > WACC = Good, and ROIC < WACC = Bad can help you make a snap judgement, but it doesn’t help you to understand the story that produced those figures, and it doesn’t increase your financial literacy.
Conclusion
I understand that if you’re not familiar with Financial Analysis, this can all seem very complicated and confusing. However, understanding ROIC can help you better assess your investments. Comparing a company’s ROIC to its WACC, and watching a company’s trend can help you to understand whether or not you should invest in that company. Comparing the ROIC trends between companies can likewise help you in choosing the best between investments.
Although this may be difficult, ROIC is a powerful tool to have in your investing toolbox.