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Return on invested capital

Return on Invested Capital (ROIC) is a measure of financial performance and a financial performance forecasting tool.

Expanded Definition

Return on invested capital is expressed as a percent and measures how well a company utilizes the capital invested in the business. It is similar to return on equity but takes debt into account.

<math>ROIC = \frac{NOPAT}{Invested\ capital}</math>

NOPAT means Net Operating Profit After Taxes. Take operating profit and subtract taxes (usually 35%).

<math>NOPAT = Operating\ profit * (1 - 0.35)</math>

Invested capital is usually defined as total assets minus non-interest bearing current liabilities minus excess cash.

Non-interest bearing current liabilities are things like accounts payable, wages payable, and similar -- liabilities that don't require an interest payment.

Excess cash is usually defined as cash beyond 0% to 20% of revenue and is meant to be cash that the company doesn't need to keep running. The percentage to use is left up to the investor or analyst, but we Fools think it's better to be conservative. The amount depends on the type of company. For instance, for a restaurant, which turns cash into inventory, sells it rapidly turning it back into cash, one might use a very small percentage of revenue as "necessary" cash, subtracting out most of the cash being carried. For an industrial manufacturer, where it can take a long time to run cash through the business, a much larger percentage would be necessary. The cash conversion cycle gives a clue as to which the company is.

In general, the market is willing to pay a higher multiple for stocks with higher ROICs.

Example

Suppose a company has the following characteristics:

  • Revenue of $246 million
  • $37 million in operating profit
  • Total assets of $259 million
  • Non-interest bearing current liabilities of $13 million
  • Cash of $17 million
  • Cash conversion cycle of 20.3 days.

<math>NOPAT = $37\ million * (1 - 0.35) = $24.05\ million</math>

The company has a fairly rapid cash conversion cycle, so we'll say that necessary cash is 3% of revenue, or $7.38 million. That means excess cash would be $9.62 million.

<math>Invested\ capital = $259\ million - $13\ million - $9.62\ million = $236.38\ million</math>

Using those two, then:

<math>ROIC = \frac{$24.05\ million}{$236.38\ million} = 10.2%</math>

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