What is ROIC?
Return on Invested Capital (ROIC) is a measure of the extent of a company’s earnings from capital invested in its business. Contrary to popular misconception, it is NOT equal to the Profit After Tax (PAT) margin of the company. The PAT margin measures returns generated by the company over its revenues; ROIC measures returns generated by the company over total capital invested or mobilised by the company in its business. ROIC gives the correct picture of how the company is using its capital and can be used as a tool to compare returns from various investments.
How is ROIC calculated?
ROIC is usually calculated as a percentage and expressed as a trailing twelve month value. It can be mathematically represented as follows.
How should one analyse ROIC value?
ROIC by itself, will give little indication of efficiency of capital usage by any company. It should always be compared with cost of capital of the company. A higher value of ROIC than its cost of capital implies that the company is creating a value by investing in its business whereas a lower value of ROIC than its Cost of Capital implies the company is destroying value by investing in its business. Let’s say, you borrowed funds from family/friends/Banks at an interest rate of 13% and invested the amount in your company. Your Cost of Capital is 13% in this case. So your business should give you Returns or ROIC of more than 13% on the invested amount, for the business to be rewarding. OR let’s say you had investments in FD (8.5%)/stock markets where you were getting returns of 20%. In this case your cost of capital is 20%. So your business should generate returns of at least 20%, for it to generate any positive value for you. Therefore, ROIC is more effective when compared to your cost of capital and is essentially a good tool for evaluating your best investment options.