Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in
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 ...
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 "languag ...
, 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
) by the average book-value of the invested capital
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
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 ratio The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The tw ...
s or calculating the weights for the weighted average cost of capital
(WACC)), ROIC uses book values of the invested capital
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 invested capital
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 weighted average cost of capital
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 "
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.
* Cash flow return on investment
*'' Fairfield Plaza, Inc. v. Commissioner
Negative return (finance)
The term negative return is used in business or 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 o ...
In economics, profit maximization is the short run or long run process by which a firm may determine the price, input and output levels that will lead to the highest possible total profit (or just profit in short). In neoclassical economics, ...
Rate of profit
In economics and finance, the profit rate is the relative profitability of an investment project, a capitalist enterprise or a whole capitalist economy. It is similar to the concept of rate of return on investment.
Historical cost ''vs.'' market ...
* Rate of return on a portfolio
* Recovery of capital doctrine
* Return on assets
* Return on brand
* Return on capital employed
Return on net assets The return on net assets (RONA) is a measure of financial performance of a company which takes the use of assets into account. Higher RONA means that the company is using its assets and working capital efficiently and effectively. RONA is used by in ...
Tendency of the rate of profit to fall
The tendency of the rate of profit to fall (TRPF) is a theory in the crisis theory of political economy, according to which the rate of profit—the ratio of the profit to the amount of invested capital—decreases over time. This hypothesis ...