Return on capital

Quick definition

Return On Invested Capital (ROIC) represents the earnings that a company gets from the capital it has invested.

Key details

• Return on capital is a measure of how much money a business relative to its investment
• ROIC helps judge whether a company is spending effectively
• It’s a benchmark metric to compare companies in similar industries

What is return on invested capital (ROIC)?

It is a profitability ratio that measures the returns that investors are receiving back after investing in the company’s capital.

In this case, the capital here includes the total amount of long-term debt and the total amount of shares, both ordinary and preferred (also referred to as “equity”). This means that the capital invested is taken as the total amount needed for the capital in the company, not just the assets that the company has acquired.

Companies have to invest in their ability to produce more and expand their capacity, thereby resulting in an increase in their earnings. The kind of investment here could be in the form of additional inventory, better machinery, and improved technology. When a company spends its money on these investments, it will expect that they will generate additional earnings, which are referred to as returns on the investment employed.

What does return on capital tell us?

ROIC is used by investors to measure the returns a company has made after it has paid out its equity capital and its debt. The investors check the percentage return that they are earning from the capital that they have invested. Using the ROIC, they are then able to determine if the company is efficient in generating maximum income in its allocation for the use of investors’ funds.

A company uses ROIC to benchmark its value and market placement (competitive advantage) in comparison to other companies in its industry. Value is considered as having been added if the ROIC is above 2%. If it is below 2%, then the capital that the company has invested has not added any value to it and has not generated any returns.

Illustrations of Return on Invested Capital

Illustration one

Company D closes its year 1 with a net profit of $200,000. Management decides it wants to increase its sales and profits and therefore raises capital amounting to $2,400,000 by selling stock in year 2. The company has retained earnings of $300,000 to be used for year 2. At the close of year 2, the company pays out dividends to its shareholders amounting to $400,000 and makes a net profit after tax of $900,000. Let us compute the ROIC for year 2.

Summary of company figures:

Net profit (after tax) in year 2: $900,000

Dividends to shareholders: $400,000

Capital invested in total: $2,400,000

Retained earnings for year 2: $300,000

Let us calculate the Operating Income:

Net Operating Income = Net Operating Profit after Tax – Dividends

= $900,000 – $400,000

= $500,000

Let us calculate Total Capital Invested:

Total Invested Capital = Value of stocks sold + Retained earnings

= $2,400,000 + $300,000

= $2,700,000

Now let us calculate the ROIC:

ROIC = Net Operating Income

Invested Capital

= $500,000

$2,700,000

= 18.5%

This ROIC translates that Company D has a good capacity to get returns. This means that when $2,700,000 is invested in the company, it will generate $900,000 profit after tax is deducted, with a capacity to pay out $400,000 of dividends to its shareholders.