Return On Invested Capital (ROIC) is the best way to analyze the profitability of the core business of a company. Operating Performance of a company is measured by ROIC. ROIC measures the return generated on all the capital invested by the company.
Many investors use Return on Equity(ROE) or Return on Capital Employed(ROCE) for doing their analysis, but I prefer ROIC over other two ratios as it nullifies any drawbacks faced by them.
ROIC Formula :
As mentioned above, Return on Invested Capital measures the return generated by the company on invested capital. It is a product of two ratios 1)Operating Profit Margin 2) Capital Turnover Ratio.
1) Operating Profit Margin = Operating Profit/Sales
2) Capital Turnover Ratio = Sales/Net Fixed Asset + Net Working Capital
Net Working Capital = (Account Receivables + Inventories) – Account Payables.
ROIC = Operating Profit Margin * Capital Turnover Ratio
ROIC = Operating Profit/Invested Capital
Invested Capital = Net Working Capital + Net Fixed Asset.
Here, we have to check which factor has affected the ROIC of a company. OPM, Capital Turnover Ratio or both.To get in-depth detail about ROIC it’s better to use ROIC = Operating Profit Margin * Capital Turnover Ratio as a formula.
Also Read: How To Read A Cash Flow Statement
Let’s try to understand with the help of an example. We will take VST Tillers Tractors Limited.
|Invested Capital (a + b)||56||78||119||133||205||234||245||313||299||294|
|Working Capital (b=c+d-e)||28||40||68||80||148||157||121||178||172||167|
|Capital Turnover Ratio||3.35||3.51||2.89||3.21||2.59||2.05||2.54||1.76||2.16||2.36|
|ROIC = OPM * Capital Turnover Ratio||40%||56%||52%||51%||36%||31%||48%||32%||37%||33%|
As it can be seen that VST Tillers Tractor Limited has managed to give an average ROIC of 42% in the past 10 years which is great and it can be described as a great wealth creator company if we look at Return on Invested Capital ratio.
The company has managed to maintain a good OPM range of 14% to 18% and at the same time, its capital turnover ratio is also good in the range of 2-3 in past couple of years. It can be concluded that a stable level of OPM and capital turnover ratio has resulted in great ROIC of the company.
We need to look the movement of both OPM and Capital Turnover Ratio to understand the ROIC of the company.
It’s up to Investor to set a benchmark for minimum ROIC Company. For a non-financial company, I prefer ROIC of above 18%. ROIC should be looked for a past 10 years rather than looking for 1or 2 years in isolation.
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