Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in

finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...

, valuation and

accounting Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "language ...

, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders.Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 36. It indicates how effective a company is at turning capital into profits. The ratio is calculated by dividing the after tax

operating income In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and op ...

(

NOPAT In corporate finance, net operating profit after tax (NOPAT) is a company's after-tax operating profit for all investors, including shareholders and debt holders.Moneyterms.co.ukNOPAT/ref> NOPAT is used by analysts and investors as a precise and ...

) by the average book-value of the

invested capital Net operating assets (NOA) are a business's operating assets minus its operating liabilities. NOA is calculated by reformatting the balance sheet so that operating activities are separated from financing activities. This is done so that the operati ...

(IC).

Return on invested capital formula

: There are three main components of this measurement that are worth noting: * While ratios such as

return on equity The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on '' ...

and

return on assets The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue. ROA can be computed as below: :\mathrm = \frac This number tells you what the company can do with what it has, ''i.e.'' how many dolla ...

use net income as the numerator, ROIC uses net operating income after tax (NOPAT), which means that after-tax expenses (income) from financing activities are added back to (deducted from) net income. * While many financial computations use market value instead of book value (for instance, calculating debt-to-equity ratios or calculating the weights for the

weighted average cost of capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by ...

(WACC)), ROIC uses book values of the

as the denominator. This procedure is done because, unlike market values which reflect future expectations in efficient markets, book values more closely reflect the amount of initial capital invested to generate a return. * The denominator represents the average value of the

rather than the value of the end of the year. This is because the NOPAT represents a sum of money flows, while the value of the invested capital changes every day (e.g., the invested capital on December 31st could be 30% lower than the invested capital on December 30th). Because the exact average is difficult to calculate, it is often estimated by taking the average between the IC at the beginning of the year and the IC at the end of the year. Some practitioners make an additional adjustment to the formula to add depreciation, amortization, and depletion charges back to the numerator. These charges are considered by some to be "non-cash expenses" which are often included as part of operating expenses. The practice of adding these back is said to more closely reflect the cash return of a firm over a given period of time. However, others (such as Warren Buffett) argue that depreciation should not be excluded seeing that it represents a real cash outflow. When a company purchases a depreciating asset, the cost is not immediately expensed on the income statement. Instead, it is capitalized on the balance sheet as an asset. Over time, the depreciation expenses on the income statement will reduce the asset value on the balance sheet. In turn, depreciation represents the delayed expensing of the initial cash outflow that purchased the asset, and is thus a rather liberal accounting practice.

Relationship with WACC

Because financial theory states that the value of an investment is determined by both the amount of and risk of its expected cash flows to an investor, it is worth noting ROIC and its relationship to the

(WACC). The cost of capital is the return expected from investors for bearing the risk that the projected cash flows of an investment deviate from expectations. It is said that for investments in which future cash flows are incrementally less certain, rational investors require incrementally higher rates of return as compensation for bearing higher degrees of risk. In corporate finance, WACC is a common measurement of the minimum expected weighted average return of all investors in a company given the riskiness of its future cash flows. Since return on invested capital is said to measure the ability of a firm to generate a return on its capital, and since WACC is said to measure the minimum expected return demanded by the firm's capital providers, the difference between ROIC and WACC is sometimes referred to as a firm's "excess return", or "

economic profit In economics, profit is the difference between the revenue that an economic entity has received from its outputs and the total cost of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs. It ...

References

{{Financial ratios Financial ratios Investment indicators

Return on invested capital formula

Relationship with WACC

See also

References