What is Return on Invested Capital (ROIC)?

Return on Capital Invested Capital (ROIC) is one of the profitability ratios that help us understand how the firm uses its invested capitalInvested CapitalInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash read more i.e., equity and debt, generating profit at the end. This ratio is so important for investors before the investment because it gives them an idea about which company to invest in. Because the percentage of profits generated from the invested capital is a direct ratio of how good a company is doing in transforming its capital into income.

While calculating this ratio, one thing you need to remember is whether you are taking the core income of the business (i.e., most of the time, “net income” of the firm) as a measuring grid. The business can generate income from other sources, but it shouldn’t be considered if it’s not from its core operations.

ROIC of Home Depot shows an upward trend and currently stands at 25.89%. What does this mean for the company, and how does it impact the investors’ decision-making process?

ROIC Formula

ROIC Formula = (Net Income – Dividend) / (Debt + Equity)

Let’s take each item from the equation and explain what they are.

As a business or as an investor, if you want to calculate this ratio, the first thing you need to consider is Net Income. This Net Income should be coming from the main operations of the business. That means “Gains from foreign currency transactions” or Gains from other currency transactions” wouldn’t be included in Net Income.

If you find too many incomes from other sources, calculate the Net Operating Profit after Tax (NOPAT). You won’t find NOPAT in the financial statementsThe Financial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, but you can calculate it by following this simple formula –

Also, have a look at the Ratio analysisRatio AnalysisRatio analysis is the quantitative interpretation of the company’s financial performance. It provides valuable information about the organization’s profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more Guide.

NOPAT Formula = Operating Income before Tax * (1 – Tax)

Now how would you get the figure of Operating Income? To find out operating incomeFind Out Operating IncomeThe operating income formula (also known as the EBIT formula) is a profitability formula that helps in calculating a company’s profits generated from core operations. The formula is a decision tool that allows investors to assess how much gross income will result in profit for a firm. The operating income can be calculated by deducting the cost of goods sold and operating expenses from total revenue.read more, you need to look into the income statement and find out the operating profit or operating income. Let’s understand this with an ROIC example –

  • To calculate NOPAT, all you need to do is deduct the tax proportion from the Operating Income.In the case of Dividends, if you have paid any dividend during the year, you need to deduct that from Net Income.Debt is what the firm has borrowed from a financial institution or banks, and equity is what the firm has sourced from equity shareholders.

Interpretation

From the explanation, you may have understood that Return on Capital is not an easy ratio to calculate. But irrespective of all these complexities, if you can come up with Return on Capital, it would help a great deal in deciding how the company is doing. Here’s why –

  • You are considering net income or NOPAT and how much capital the business has invested. It includes most of the things into account while calculating the ratio. So it produces the right percentage of the profit at the end of the year.This ratio emphasizes the income from operations more and doesn’t always include other income. That means it’s the purest form of calculation to ascertain the profit percentage.

Return on Invested Capital Example

If you find the ROIC of a company more than 20% for the last few years, you may think about investing in the company, but make sure that you consider every figure and detail while calculating this ratio.

ROIC Calculation for Infosys

We will look at Infosys’ income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more and balance sheet for the year-end 2014 and 2015 and then will calculate the ROIC ratio for both years.

Let’s have a look at the Balance Sheet first.

Balance Sheet as of 31st March 2014 & 2015 –

source: Infosys Annual Report

Statement for profit and loss for the year ended 31st March 2014 & 2015 –

Now, let’s calculate the return on invested capital.

  • As there is a negligible amount of other income, we took the real income into account while coming up with the year’s profit. And also, there is no dividend mentioned, so we didn’t deduct the amount from the profit.As Infosys is a fully debt-free company, only shareholders’ funds are considered capital invested.

Let’s come to interpret the Return on the Invested Capital ratio for both years. We could easily say that Infosys is a company that has been successful in generating a great Return on Capital for both of the years. So from the investors’ point of view, Infosys may seem a good place to invest their money into.

Why Home Depot’s Return on Invested Capital is Increasing?

Home Depot is a retail supplier of home improvement tools, construction products, and services. It operates in the US, Canada, and Mexico.

When we look at Home Depot’s ratio, we see Return on Capital of Home Depot has climbed up steeply since 2010 and is currently at 25.89%.

What are the reasons for such an increase?

source: ycharts

Let us investigate and find out the reasons.

Return on Invested Capital ratio can increase either because of an increase in 1) Net Income 2) decrease in Equity 3) Decrease in Debt

# 1 – EVALUATING HOME DEPOT’S Net Income

Home Depot increased its Net Income from $2.26 billion to $7.00 billion, approximately 210% in 6 years. It significantly increased the numerator and is one of the most important contributors to the uptick in ROIC ratio.

#2 – EVALUATING HOME DEPOT’S SHAREHOLDER’S EQUITY

We note that the shareholder’s equity of Home Depot has decreased by 65% in the last four years. Declining shareholder’s equity has contributed to the decrease in the denominator of the ROIC ratio. We note that the decrease in Shareholder’s Equity has also contributed meaningfully to the increase in the Home Depot ratio.

If we look at Home Depot’s Shareholder’s Equity section, we find the possible reasons for such a decrease.

  • Accumulated Other Comprehensive Loss has resulted in lowering shareholders’ equity in both 2015 and 2016.Accelerated BuybacksAccelerated BuybacksAccelerated share repurchase (buyback) is a strategy adopted by a publicly-traded company to acquire its outstanding shares in the market from the clients in large blocks via an investment bank.read more were the second and most important reason for the decrease in Shareholder’s equity in 2015 and 2016.

#3 – Evaluating Home Depot Debt

Let us now look at Home Depot’s Debt. Home Depot’s debt increased from 9.682 billion in 2010 to $21.32 billion in 2016. This 120% increase in debt resulted in lowering the ROIC ratio.

Summary –

We note that Home Depot’s Return on Invested Capital ratio increased from 12.96% in 2010 to 25.89% in 2016 because of the following –

  • Net Income increased by 210% in the period from 2010-2016 (a major contributor to the numerator)Shareholder Equity decreased by 65% in the corresponding period. (a major contributor to the denominator)An overall increase in the ROIC ratio because of the two factors above (1 and 2) was offset by the 120% increase in debt in the corresponding period.

Industry-wise ROIC Ratios

What is the right benchmark for a great ratio? The answer is it depends!

Below we have documented some industry Return on an Invested Capital ratios that will help you with the ballpark figuresBallpark FiguresA ballpark figure is a rough estimate given to understand the value of something, which can help make important decisions. It is considered a logical measurement that accounts for a margin of error.read more of what seems to be a good ROIC ratio.

Two important points to note here –

  • Capital Intensive Sectors like Telecom, Automobile, Oil & Gas, Utilities, Departmental Stores tend to generate low ROIC.Pharmaceutical, Internet Companies, Software Application companies tend to generate higher Returns on an Invested Capital ratio.

Let us look at some of the top companies in some important sectors. Please note that the source of Industry Return on the Invested Capital ratio is ycharts.

Departmental Stores Industry Example

  • We note the following in the example of the Internet and content industry. We note that Nordstorm has an ROIC ratio of 13%; on the other hand, Macy’s has a ratio of 8.7%Many companies like Sears Holding, Bon-Ton Stores, JC Penney Co show a negative Return on Invested Capital ratio.

Internet and Content Industry Example

  • Internet and Content companies are generally not capital intensive like the Utilities or Energy Companies. Therefore, we can see that this industry’s Return on an Invested Capital ratio is higher.Alphabet, Facebook, and Baidu have a ratio of 15%, 20%, and 35%, respectively.However, Yahoo, JD.Com, and Twitter have a negative Return on Invested Capital.

Telecom Industry Example

Please see below the list of top Telecom Companies in the US, along with ROIC calculation and Market CapitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more.

We note the following in the ROIC Example of the Telecom industry.

  • We note that the Telecom sector is a capital-intensive sector, and its Return on the Invested Capital ratio is on the lower side.AT&T, China Mobile, and Verizon have a ratio of 5%, 12%, and 10%, respectively.Vodafone Group, on the other hand, have a negative ratio of -4%

Oil & Gas E&P Industry Example

  • We note that the Oil & Gas sector is highly capital intensive and has a lower ROIC ratio.A slowdown in the Oil & Gas sector since 2013 has led to declining profitability and losses in most cases.Of these top Oil & Gas companies, eight companies have a negative ratio.Only two companies, CNOOC and Concho resources, have a positive Ratio of 4% and 1%, respectively.

Automobile Industry Example

  • Again, the Automobile Sector is highly capital intensive, and we note that most companies show a lower ROIC ratio.Toyota Motors, Honda Motor, and General Motors have a ratio of 6%, 2%, and 8%, respectively.Tesla, on the other hand, has a negative ratio of -25%

Utilities Industry Example

  • As pointed out earlier, Utilities are also an intensive capital sector and have a lower ROIC ratio.National Grid, Dominion Resources, and Exelon have a ratio of 6.8%, 4.7%, and 1.9%, respectively.Entergy, on the other hand, has a negative ratio of -0.7%

Limitations

  • The ROIC ratio is very complex to calculate. When they need to calculate the return on invested capital ratio, investors can approach it from a different angle. They can calculate the capital invested by deducting the non-interest-bearing-current-liabilities (NIBCLS) from the total assetsTotal AssetsTotal Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more or considering the short-term debt, long-term debt, and equity. And to calculate the Net Income, there are many approaches they can take. The only thing that needs to be remembered is that the core focus of net income is the income from the business’s operations, not other income.This ratio is not suitable for people with no financial background. They often wouldn’t understand the intricacies of this ratio until they had a basic knowledge of finance.

Return on Invested Capital (ROIC) Video

  • ROTA FormulaROTA FormulaReturn on Total Assets is a measure of a company’s income proceeds left for shareholders divided by the total assets owned by the company. ROA = Net Income/Total Assets.read moreNOPAT FormulaNOPAT FormulaNOPAT, or Net Operating Profit after Tax, is a profitability measure in which a company’s profit is calculated excluding the effect of leverage by assuming that the company has no debt in its capital and, as a result, ignores the interest payments and tax advantages that companies receive by issuing debt in their capital.read moreEquity Turnover RatioCapital Gearing RatioCapital Gearing RatioCapital Gearing, also called Financial Leverage, is the level of debt that a Company utilizes for obtaining assets. It is determined as the ratio of Total Equity to Total Debt. read more

In the final analysis

After discussing everything in detail, we conclude that ROIC is a great ratio to calculate if you want to know how a firm is doing in a real sense. If the Return on Invested Capital ratio can be followed over the years, it would certainly give a clear picture of how a firm is doing. Thus, if, as an investor, you want to invest your money into a firm, calculate Return on Invested Capital first and then decide whether it’s a good bet for you or not.