Return on investment capital measures how a business utilizes its capital. Investors prefer return on investment capital (ROIC) to determine a company’s future performance. Return on investment capital helps calculate the additional returns a business generates. Many investors believe that ROIC is more useful than traditional metrics like Return on Investment (ROI) and Return on Equity (ROE).
High return on investment capital indicates sustainable growth of a company. It assures investors that every invested dollar is optimally used for growth. However, only a few companies have achieved a high return on investment capital. In this post, the basic method of how to calculate return on investment capital along with its advantages and disadvantages have been discussed. This information will help you evaluate ROIC’s importance in business.
What is Return on Investment Capital?
Return on investment capital is a metrics that assesses the financial performance of a business. It is always calculated as a percentage. Investors use it to analyze if capital allocation into various securities like stock, endowment or mutual funds is done profitably. The use of capital cannot be guessed from the profit margin. Return on investment capital provides a clear idea about how capital is being used for revenue generation. Comparing return on investment capital or ROIC with the weighted average cost of capital, offers deeper insight regarding capital utilization.
How to Calculate Return on Investment Capital
By learning how ROIC is calculated, you will realize the importance of it. Return on investment capital is measured by dividing net income and dividends by total capital. In you have net income without dividends, then net income after tax can also be used. The total capital, or invested capital, is derived from adding working capital and fixed assets. Alternatively, you can calculate it by adding total equity and total long term debt. Return on investment capital establishes a direct relationship between the total investment and operating income. It serves investors as a reliable metric to base decisions off of.
Why Calculate Return on Investment Capital
Return on investment capital is calculated as an annualized value. This value varies from one industry to another. ROIC offers more valuable insight for industries that are capital intensive. For example, such industries include oil and gases, computer hardware, retail chains and manufacturing. By calculating ROIC, you can compare your company’s performance to other companies in the industry. Of course, this is one factor of many to consider. However, it is how others will view your business too.
The return on investment capital metric tells a lot about a business. Dividing the operating income by total investment, it offers valuable insight about a business’ profitability. These insights are used to evaluate present returns while predicting future performance. Overall, return on investment capital offers an idea of the returns a company generates for its investments.
Image from http://energis.com.au/return-investment/