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What is Return on Invested Capital and How is it Calculated?

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Question: What is Return on Invested Capital and How is it Calculated?

Return on invested capital is also known as return on capital employed.

Answer:

Return on Invested Capital or return on capital employed is a profitability or performance ratio that measures how much investors in a business are earning on the capital they have invested in that business. As an example of financial analysis, return on invested capital is also a valuation measure.

Return on Capital Employed as an Example of Financial Analysis

You have to look at a company's financial statements in order to understand return on invested capital. Look at the income statement. You will see a line item for Earnings Before Interest and Taxes (EBIT). If you multiple EBIT by (1-tax rate), you arrive at Net Operating Profit after Taxes or NOPAT. NOPAT is the numerator in the equation calculating Return on Invested Capital. Sometimes, EBIT is substituted as the numerator.

NOPAT = EBIT (1 - tax rate) = Numerator

We have the numerator in the equation to calculate Return on Invested Capital so now we need the denominator. The denominator is Operating Capital. We look to the balance sheet for this information since the accounts that make up capital are on the balance sheet.

Operating Capital is made up of notes payable, long-term bonds, preferred stock, and common equity. This is a simple balance sheet and only has notes payable (the long-term bank loan entry) and common equity accounts. A more sophisticated balance sheet may have bonds and preferred stock on it. Operating capital, the denominator, is calculated by adding the average debt liabilities to the average stockholder's equity:

Operating Capital = Average Debt Liabilities + Average Stockholder's Equity = Denominator

Given this information, here is the formula for Return on Invested Capital:

ROIC or ROCE = NOPAT/Operating Capital

How do you Interpret Return on Invested Capital

Return on Invested Capital is a performance measure and it indicates how much return is generated by each dollar of operating capital. If the ROIC is greater than the firm's weighted average cost of capital, then the business is adding value. Return on Invested Capital is one of the most important valuation measures.

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