# Return on Invested Capital

Return on Invested Capital (ROIC) is a profitability ratio that compares a company's NOPAT to total invested capital. Learn how to calculate ROIC, the importance of the metric, and how investors interpret ROIC.

## What is Return on Invested Capital?

Return on Invested Capital (ROIC) is a profitability ratio that highlights a company’s profit to the total capital invested in the business. Total capital invested in the business is equal to the sum of equity and debt.

The ROIC formula is:

Return on Invested Capital = NOPAT / Invested Capital

Net operating profit after tax (NOPAT) equals a company’s operating profit after subtracting its tax expense. The NOPAT formula is:

NOPAT = Net Operating Profit x (1 - Tax Rate)

Invested capital (IC) equals total debt plus total equity less cash and cash equivalents. The IC formula is:

IC = Total Debt + Total Equity - Cash & Cash Equivalents

ROIC is expressed as a percentage since it’s a return relative to the amount of money invested in the business.

For a publicly traded company, the book value and market value of its invested capital may be significantly different. As such, it’s important to use the book value in this calculation.

Small business owners, executives, shareholders, and analysts use ROIC in order to understand the financial health and potential of a company. ROIC is a popular profitability metric to compare one company to its competitors in the same industry.

Related accounting metrics include operating profit, profit margin, return on assets, and return on equity.

## Return on Invested Capital Definition

Return on invested capital is a helpful financial metric that shows the return that a business generates from its day-to-day operations. In particular, investors can look at how a company’s return on invested capital compares to its weight-average cost of capital (WACC).
The WACC is the cost that a company can raise money and ROIC is the amount of profit that a company can generate with that capital. If ROIC is greater than WACC, the company is generating excess returns and will be valued at a premium by the market.

Unfortunately, ROIC is less useful across industries as the amount of capital needed to build a financial services company, a manufacturing company, and a consulting company are very different.

ROIC takes a profit measure from the income statement and compares it against invested capital, which is found on the balance sheet. This is fairly standard for a profitability metric.

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All things equals, a company will want a higher ROIC. A higher ROIC is better because it means the company's management is being more efficient with the capital raised.

A business can increase its ROIC by increasing its profitability, decreasing its tax rate, decreasing its outstanding debt, or decreasing its outstanding equity.

A company that has excess cash on hand could harm its return. For example, if ROIC decreases period over period it could be due to the fact that the CEO has not allocated capital properly or that new projects do not have a high enough return compared to previous projects.

## Calculate ROIC

The return on invested capital formula is:

Return on Invested Capital = NOPAT / Invested Capital

The net operating profit after tax (NOPAT) formula is:

NOPAT = Net Operating Profit x (1 - Tax Rate)

As a reminder, operating profit is also called earnings before interest and tax (EBIT).

The invested capital (IC) formula is:

IC = Total Debt + Total Equity - Cash & Cash Equivalents

Total debt is the sum of short-term debt and long-term debt. Total equity is the sum of common stock and preferred stock issued.

Cash and cash equivalents refer to paper currency, checking accounts, savings accounts, government bonds, certificates of deposits, and marketable securities.

Note that unlike return on assets and return on equity, we are not using net income as the denominator. This is because interest expense should not be taken into account when looking at ROIC.

This calculation helps us understand a company’s efficiency by looking at how they can take invested capital (whether that’s debt or equity) to generate profit.

All things equal, a company will want a higher ROIC. A higher ROIC shows that the company is being more efficient and generating more profit for every dollar invested.

## ROIC Examples

Now that we have discussed the definition and the formula, we will walk through how to calculate the ROIC of a company. The information for Company A and B for the fiscal year 2021 is provided below.

Company A FY2021

• Operating Profit: \$1,000,000
• Income Tax Rate: 35%
• Book Value of Debt: \$4,500,000
• Book Value of Equity: \$5,000,000

Company B FY2021

• NOPAT: \$3,000,000
• IC: \$12,000,000

As a reminder, you want to use the book value of invested capital in your calculations. Let’s dig into the math.

To calculate ROIC for Company A, we will need to calculate the inputs. Let’s start by solving for NOPAT.

NOPAT = Net Operating Profit x (1 - Tax Rate)

NOPAT = \$1,000,000 x (1 - 0.35)

NOPAT = \$650,000

Now that we have NOPAT, let’s calculate the denominator.

IC = Book Value of Debt + Book Value of Equity

IC = \$4,500,000 + \$5,000,000

IC = \$9,500,000

Now that we have the inputs, we can use the ROIC formula:

ROIC = NOPAT / IC

ROIC = \$650,000 / \$9,500,000

ROIC = 0.068

ROIC = 6.8%

The ROIC for Company A in 2021 was 11.8%. Let’s walk through the steps for Company B now. Since Company B gave us all the information we need, we can jump to the ROIC formula.

ROIC = NOPAT / IC

ROIC = \$3,000,000 / \$12,000,000

ROIC = 0.250

ROIC = 25.0%

Out of the two companies, Company A has a bad ROIC. Their return is almost four times lower than Company B, which means they have either raised too much money that they cannot deploy it appropriately or their operations are not efficient.

By contrast, Company B has a good ROIC because the business is able to generate higher returns than its competitor. Company B would be a more attractive opportunity for investors and be deemed more stable to lenders.

## Related Accounting Ratios

There are several accounting ratios that are related to ROIC and, when used together, provide a holistic view into a company’s financial performance.

### Operating Profit

Operating profit is the profit left after accounting for your ordinary business expenses, depreciation, and amortization. It is also called earnings before interest and tax (EBIT). The formula is:

Operating Profit = Gross Profit - Operating Expenses

Operating profit is lower down the income statement than gross profit, but not as low as net profit. This metric is displayed as a dollar value, whereas operating profit margin (operating profit divided by revenue) is expressed as a percentage.

### Profit Margin

Profit margin is the percent of a company’s profit compared to its revenue. The simplest form of the formula is:

Profit Margin = Profit / Revenue

There are several types of profit margin analysis, including gross profit margin, operating profit margin, and net profit margin.

Understanding a company’s margin at each step of the income statement is very helpful to uncover the fundamentals of the business.

### Return on Assets

Return on assets (ROA) is a financial ratio that compares a company’s net income to its total assets. The ROA formula is:

ROA = Net Income / Total Assets

Similar to ROE, ROA is a measure of company efficiency. A high ROA is better as it shows that management is using assets to generate more profit than a low ROA.

ROA might not be a helpful tool for companies with high intangible assets. An alternative to the standard ROA formula is to divide net income by the fixed assets balance.

### Return on Equity

Return on equity (ROE) is a profitability ratio that compares a company’s profitability to total shareholders’ equity. Shareholders’ equity is found on a company’s balance sheet.

This is a measure of efficiency, as it is better for a business to generate more profit with less equity investment. The return on equity formula is:

ROE = Net Profit / Average Shareholders’ Equity

ROE is expressed as a percent. The higher the number, the more efficient the company is at generating profit.

## Final Thoughts

Return on invested capital (ROIC) is an important metric for understanding if a company has a competitive advantage or moat. ROIC looks at a company’s net operating profit after tax (NOPAT) to its total invested capital (IC).
The formula depends on a company’s operating income, income tax rate, cumulative debt, and cumulative equity. By optimizing these inputs, a CEO or management team can optimize a company’s return to shareholders.

There are several ways investors can earn a return from a business. Lenders can issue debt and earn interest on the money they lend. Equity investors can look to have the value of their shares to increase or for companies to issue dividends.

Regardless of this, ROIC is a useful number that helps understand if their operations and growth are feasible. If a company has historically struggled to generate a strong ROIC and plans to dramatically increase the number in the future, it might be a warning sign.

Investors should try to understand what factors are changing (operating income, tax rate, debt, equity, company strategy, etc.) are leading to these future results.

Like ROA and ROE, ROIC is a useful metric to compare a business to its competitors in the same industry. Because capital structure, assets, and cost of capital vary significantly, these tools are less useful when looking across industries.