What is ROIC Formula?
ROIC Formula (Return on Invested Capital) is considered as profitability and a performance ratio and is calculated based on the total cost and the return generated, returns are the total net operating profit after tax while investments are calculated by subtracting all the current liabilities from its assets.
The formula is represented as below,
Explanation
ROIC calculation is done by using the Net Operating Profit. Once the Operating Profit is calculated, we deduct Tax from the same, as we need Net Profit. It is the “Return” that the company has generated from all the capital it has used up during the period.
The denominator is the total invested capital by the company during that particular period. It may include capital raised from the market plus the company’s equity.
In this ratio, we are trying to determine the percentage of conversion of capital into returns by the company. Hence, this is used as a profitability ratio.
Net Operating Profit after Tax
It is the profit generated after deducting all possible deductions from the reported sales and profit amount. However, we mention only Tax in the formula as a deduction because; Tax is an essential component in calculating profits. It is an external component that is paid to the government of the Land. Actual profit has arrived only after Taxes are deducted. Again, if the company is listed in markets, we also need to deduct any dividends being paid out from Net Profit to arrive at this numerator.
Total Invested Capital
It is the total amount invested by the company during that particular period. This amount includes its equity plus the debts it has raised from markets (if any).
Example of ROIC Formula (with Excel Template)
Let’s see some simple to an advanced example to understand it better.
Example #1
Company ABC manufactures Copper wires. In the year 2016, its net profits were $500,000. The company management decided to enhance sales and thus profits as an objective for the year 2017. For doing this, they raised capital in the form of stocks amounting to $2.5M. The retained earnings to be used for 2017 were $100,000. At the end of 2017, they made a Net profit (after tax deductions) of $575,000 and paid $100,000 as dividends to stockholders. We need to do the calculation of ROIC for 2017.
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- Net Profit after Tax: $575,000
- Dividends paid out: $100,000
- Total Invested Capital: $2,500,000 + $100,000 = $2,600,000
In the below-given template is the data of Company ABC for the ROIC calculation.
So, the Calculation of ROIC of Company ABC will be as follows:
Return on Invested Capital Formula = Net Operating Profit after Tax -Dividends / Total Invested Capital
ROIC =($575,000 – $100,000)
So, Return on Invested Capital will be:
Return on Invested Capital of Company ABC =18.3%
Analysis: The company has a good return capacity. It means to say that if we invest 2.5M in the company, it generates $575K of profit after all tax deductions, with a capacity to repay $100,000 to its stockholders as well.
Example #2
Best Paints Ltd. has reported its net profit after taxes as $100,000 in 2017. The total invested capital for the firm is $2,000,000, wherein the total debt component is $800,000, and the rest is equity. ROIC calculation for Best Paints and analyze it for investing decisions.
In the below-given table is the data of Best Paints Ltd for calculation of ROIC.
Therefore, the Calculation of ROIC of Best Paints Ltd will be as follows,
ROIC = $100,000 /$2,000,000
So, Return on Invested Capital of Best Paints Ltd will be:
ROIC of Best Paints Ltd = 5.0%
Analysis: ROIC for the firm is only 5%. However, it should be noted that the total invested capital of $2M for the year, the major component is equity ($1.2M), with a debt of only $0.8M. Hence, the company would have to repay more to the investors than the debt holders.
Example #3
Triumph Solutions makes a net profit of $500,000 in 2015. The total invested capital is $1,800,000 for the year. The legal tax rate is 40%. Calculate the ROIC for Triumph Solutions for 2015.
In the below-given table is the data of Triumph Solutions for calculation of ROIC.
- Net Profit (before taxes): $500,000
- Total invested capital: $1,800,000
- Tax Rate: 40%
Therefore, Calculation of ROIC of Triumph Solutions will be as follows,
ROIC=$500,000 (1-0.4) / $1,800,000
So, Return on Invested Capital of Triumph Solutions will be:
ROIC of Triumph Solutions =16.67%
ROIC Calculator
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Relevance and Uses
ROIC is majorly used while analysts are working on company analysis. Majorly it is relevant for the following uses:
- ROIC Formula is a measure of how well a company can convert its capital into returns. Hence, this ratio helps investors understand returns from their investments.
- With results calculated over a while for a particular company, one can follow the company’s growth pattern and use this trending for forecasting the company’s typical plans in the future.
- ROIC sometimes also suggests the capital structure of the company. With the breakup of the total invested capital to equity and debt, one can try to analyze the debt and equity ratio invested by the firm and, after that, understand its related future prospects.
- Analyzing ROIC over a period of time can enable the company to understand its growth trend, and likewise make suitable decisions for future investments and/or renewals and liquidation of existing debt components.
Conclusion
ROIC is a measure of the income generated by a company from its investments. The better the ratio, the better and more profitable it is to invest in the company. However, it is essential to understand that the denominator used is “total invested capital,” and not particularly debt or equity. Hence, analyzing the structure of its components would give a much better understanding to investors and analysts. A higher debt component may also mean that the company is using up its debt to generate returns – it may require to repay a higher component of returns to its loans.
Thus, a complete and true understanding of the company’s returns would only be made after each component of the numerator and denominator are properly analyzed.
Recommended Articles
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