Return on invested capital (ROTC) is a ratio that links average assets with operating profit. It is immune to artificial inflation caused by debt-financed growth.
Like other financial ratios, ROIC results vary by industry. For example, a manufacturing company might have more of its capital tied up in plants and equipment than a retail business.
Profitability
Return on total capital, also known as return on invested capital, is a profitability ratio that expresses recurring operating profits as a percentage of net operational assets. It does not include expenses related to capital structure, such as interest, which makes it an accurate reflection of the company’s profit margin. It’s a popular metric among investors, as it can help them identify profitable companies. It’s also useful for managers inside of a company, as they can use it to compare their own performance with competitors.
What sets ROCE apart from other metrics is that it considers both debt and equity financing, whereas others only look at shareholder equity. A consistently high ROCE can indicate a competitive advantage and management efficiency. It’s important to note, however, that this metric can be impacted by corporate capital allocation decisions unrelated to core operations. For this reason, it’s often best used in conjunction with other profitability measures.
Growth
The growth of return on total capital relates to how much profit is generated from the investment of equity and debt holders. It can be calculated as a ratio by dividing earnings before interest and tax (EBIT) by capital employed. It is a useful indicator of the operational profitability and efficiency of a business. A growing ROCE suggests that a company is utilizing its assets and financial leverage effectively, generating more sales per dollar of invested capital.
It is important to note that the return on capital employed calculation only includes shareholders’ equity and non-current liabilities, excluding current debt. Also, the calculations may differ depending on whether EBIT or NOPAT is used, although it is generally accepted that NOPAT represents a more accurate picture of a company’s profits since it excludes taxes paid by investors.
When evaluating investments, it is important to know your starting point, which is known as your basis. Any appreciation above your basis is a capital gain and any depreciation below your basis is a capital loss.
Valuation
Return on total capital can be a valuable tool for investors to analyze and compare companies. It measures how well a company is managing its assets and equity to generate profits.
A company with a low ROIC may be struggling to make a profit from its investment, which can scare off potential investors or lenders. A high ROIC can signal that a company is growing and investing its capital wisely.
To calculate ROIC, start with the company’s net income and total assets figures from the income statement and balance sheet for a period. Then subtract total liabilities from total assets to obtain the invested capital figure. It’s important to use book value of investments instead of market value when calculating this ratio because it reflects the initial investment and not expected future returns in efficient markets.
The value of this ratio can be distorted if a company is “playing games” with its balance sheet, says Knight, such as by reducing long-term debt through leverage or transferring debt to other entities. It’s also important to understand the difference between ROIC and return on equity.
Risk
In order to calculate return on total capital, subtract dividends from net income and divide it by invested capital. Invested capital represents the total amount of capital that is active in the company, including debt and shareholders’ equity. It does not include other non-active assets, such as investments in other companies or real estate.
The goal of this ratio is to determine how efficient a business is at turning investor capital into profits. The higher the ROIC, the more profitable a company is.
A company can improve its ROCE by cutting costs, increasing sales or returning capital to shareholders. However, there is no set target for a good ROIC, and it can vary by industry. For example, technology and service companies generally have more intangible assets, which can be difficult to evaluate. In contrast, manufacturers tend to have more tangible assets, which can be easy to evaluate. Therefore, they have lower ROIC ratios than services or technology companies.
