Return on Invested Capital

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What is Return on Invested Capital? Description

ROIC is an instrument that can be used for measuring the historical performance of a business unit or of an entire company.

Discounted Cash Flow ultimately drives the (future) value of any company (leading indicator). However, short-term cash flow results are not useful for performance measuring, because cash-flows are easy to manipulate. For example by delaying capital spending, by postponing advertising campaigns or by decreasing R&D levels. ROIC is a lagging indicator; it provides information on how a company has performed in the past.

Usage of Return on Invested Capital. Benefits

The ROIC model is often used to assess the value creation capabilities of a firm or firms in an intuitive way. High (relative) ROIC levels are seen as proof of a strong company and/or solid company management. However great care should be taken. A high ROIC may just as well be an indicator of poor management, caused by harvest behavior, by ignoring growth possibilities, and by long-term value destruction.

Limitations of Return on Invested Capital. Disadvantages

Since Return on Invested Capital is an accounting-based measure, it suffers the following potential concerns:

  • Can be manipulated by management,
  • Is influenced by accounting conventions and by changes in accounting conventions, and
  • Is affected by inflation and currency exchange movements.

What can be said is that companies earning less than their Cost of Capital usually can not create value by growing alone, unless their Return on Invested Capital moves up above the Cost of Capital (WACC).

Calculation of ROIC. Formula

ROICNet Income After Tax       =                                      After Tax Operating Earnings                                    

                Invested Capital                       Total Assets - Excess Cash - Non-Interest-Bearing Current Liabilities

More accurately, ROIC for a single time period  =   Net Operating Earnings before Interest and Amortization Charges, but after Cash Taxes    

                                                                                        Total Assets - Excess Cash - Non-Interest-Bearing Current Liabilities

Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive Guide

Book: Ciaran Walsh - Key Management Ratios

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Compare with:  EBIT  |  EBITDA  |  Economic Value Added  |  Cash Ratio  |  Current Ratio  |  Earnings Per Share  |  Return on Equity  |  Return on Investment  |  Return on Capital Employed

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