Managing Your Business for Profitability – Understanding Return on Invested Capital 

One mistake I see many small business owners make is to focus on the “bottom line”, i.e., the profits of the business, while ignoring the amount of capital necessary to generate those profits.  

Profit as a stand along measure tells us relatively little about the economics of the business. For example, consider two companies each earning $1 million in operating profits. Without knowing the amount of capital employed in the business, we have no way of knowing which business has the superior economics.  

Suppose one business has $2 million in total capital and the other has $200 thousand in total capital. Obviously, these two businesses have very different economic returns – the business with $2 million in total capital is generating a 50% return on capital employed in the business while the business with $200 thousand in capital is generating a 500% return on capital employed. 

So, one measure we will want to look at closely is return on invested capital (ROIC). 

ROIC Defined 

Return on invested capital, or ROIC, measures the amount of operating profit generated for each dollar of total capital (both debt and equity capital).  

The formula for ROIC found in many finance textbooks is: 

ROIC = NOPAT ÷ Average total capital 

Where NOPAT is net operating profits after taxes, a measure of after-tax operating profits excluding debt and average total capital is the average of total capital at the beginning of the period and total capital at the end of the period. 

Now, this measure doesn’t work very well unless the company is following GAAP (generally accepted accounting principles). This means either keeping two sets of books – one under GAAP and one for tax reporting – or keeping detailed supplementary schedules for a number of accounts. However, even with “clean” financial statements calculated under GAAP, we are still likely to have to make a number of adjustments to the financials to better reflect economic reality. 

Calculating NOPAT 

Net operating profits after taxes (NOPAT) is a proxy for the amount of normalized discretionary cash flow which the company produces from sustainable operating sources, ignoring the impact of financing costs. To get to an accurate NOPAT figure, we may have to make a number of adjustments to the P&L statement. For example, we’ll remove any nonrecurring revenues and add back any nonrecurring expenses.  

After we have made appropriate adjustments to the P&L, we add back interest expense. We do this because we are calculating the return to all capital providers and therefore ignore financing costs. Adding interest back to pretax operating profits gives us earnings before interest and taxes (EBIT). We then subtract from EBIT an appropriate provision for taxes. The result is NOPAT. 

Calculating Invested Capital 

For invested capital, we take the average of financing liabilities and shareholders’ equity at the beginning and end of the period: 

Average invested capital = [(beg. Debt + beg. Equity) + (end. Debt + end. Equity)] ÷ 2 

For example, suppose we want to calculate average invested capital for the calendar year. We add the sum of equity and debt at the beginning of the year and the sum of equity and debt at the end of the year. We then divide the result by 2. 

We may have to adjust the balance sheet just as we adjust the profit and loss statement. For example, we want to remove any non-operating assets, such as excess cash or marketable securities, from the balance sheet and adjust shareholders’ equity accordingly. 

Another adjustment we may have to make is for operating leases. If we are preparing financial statements according to GAAP, we will have to recognize a right-of-use asset and corresponding liability for any operating leases with terms greater than 12 months. This amount is calculated as the present value of the contractual lease payment over the term of the lease, using the company’s cost of borrowing as the discount rate. This treatment of operating leases allows investors to compare firms which lease their assets against firms which own and finance their assets. However, the operating lease payments are fully expensed under GAAP. Operating lease accounting is a bit tricky, and we’ll address this further in a subsequent post. For now, we recognize that operating leases will require two adjustments when calculating ROIC. The first adjustment is to add back to operating profit the implied interest in the lease payments. The second adjustment is to make sure to include the operating lease liability in total debt (the right-of-use asset will be included in shareholder’s equity). 

So, what exactly is invested capital? Invested capital is all of the monetary capital which has been injected into or retained in the business. Generally, invested capital will come in two forms: debt and equity. Debt represents the balance of the company’s borrowings. Equity is the sum of (a) the initial amount of owner capital placed into the business in return for stock shares, (b) the amount of earnings retained in the business, (c) any additional owner contributions and share issuance, and (d) any transactions which are accounted for directly into equity. 

Calculating ROIC with an Example 

Sue is the CFO of a local heating and cooling company and must prepare ROIC calculations for a year-end management meeting and financial review. The executives are meeting in mid-January of 2023. The financial information for 2022 calendar year is as follows: 

• $2,500,000 in profit before interest and taxes reported under GAAP 
• $200,000 gain on the sale of old equipment  
• $50,000 in legal expenses associated with the settlement of a lawsuit with a former employee 
• The company leases its headquarters and recognizes an $800,000 right of use asset and corresponding lease liability at the beginning of the year, and a $750,000 right of use asset and corresponding lease liability at the end of the year. The implied interest on this lease was $64,000 for the year 

• At the beginning of the year, debt obligations were $1,000,000 and shareholders’ equity was $600,000 
• At the end of the year, debt obligations were $1,300,000 and shareholders’ equity was $800,000 
• The company’s combined state and federal c-Corp tax rate is 28% 

Sue begins the calculation of NOPAT as follows:  

NOPAT = (EBIT – nonrecurring revenue + nonrecurring expenses + implied interest expense on operating leases) x (1 – tax rate) 

So, the company’s 2022 NOPAT was: 

($2,500,000 – $200,000 + $50,000 + $64,000) x (1 – .28) = $1,738,080 

Sue then calculates the company’s average invested capital: 

Total capital = Total debt + operating lease liabilities + shareholders’ equity 

Beginning capital = 1,000,000 + 800,000 + 600,000 = 2,400,000 

Ending capital = 1,300,000 + 750,000 + 800,000 = 2,850,000 

Average total capital = (2,4000,000 + 2,850,0000) ÷ 2 = $2,625,000 

Thus, the firm’s ROIC for 2022 is: $1,738,080 ÷ $2,625,000 = .66 = 66% 

Return on Incremental Invested Capital (ROIIC) 

One important variation of ROIC is the return on incremental invested capital (ROIIC). This measure tells us what the firm earned from new capital added over some period. 

To calculate ROIIC, divide the change in NOPAT over the period by the change in total capital over the same period. 

ROIIC = (Current NOPAT – Prior Period NOPAT) ÷ (Ending period capital – Beginning period capital) 

Returning to the above example, suppose that 2021 NOPAT was $1,500,000. We can calculate the ROIIC for 2022 as follows: 

(1,738,080 – 1,500,000) ÷ (2,850,000 – 2,400,000) = $238,080 ÷ 450,000 = 53% 

How to Interpret ROIC and ROIIC 

So, how do we interpret these numbers? 

For a firm to be economically viable it must earn an amount at least equal to the firm’s cost of capital. A firm’s cost of capital is also called the weighted average cost of capital (WACC). It represents a weighted average of the firm’s required equity returns and after-tax cost of debt.  

WACC = (% of equity x cost of equity) + (% of debt x after-tax cost of debt) 

For a company to create value, it must generate a return in excess of its WACC. Suppose the firm in the above example has a WACC of 17%. The firm is creating wealth for its capital holders by keeping the capital in the business, since its ROIC is significantly above its WACC. The value of the business will also be significantly greater than the value of the firm’s tangible assets, thus creating another source of value for shareholders in addition to the current yield. 

If a firm which generates returns in excess of WACC creates value, then a firm which generates returns below WACC destroys value. If the firm is unable to bring ROIC up, then it will be best to liquidate and return the capital to debt and equity holders. 

ROIIC tells a bit of a different story. Whereas ROIC shows the return on total invested capital, ROIIC focuses on the additional profit earned on the additional capital which has been employed in the business over the period. Notice that in the above example, the ROIIC is less than total ROIC. This tells us that the returns on additional investments in the business are declining. Although the firm still created value for its capital providers (ROIIC is greater than WACC), management should proceed cautiously on reinvesting in the business if they expect ROIIC to continue to decline. 

Conclusion 

Business operators often make decisions to enhance the company’s profits, while simultaneously ignoring the amount of capital necessary to support the business. 

Two measures, return on invested capital (ROIC) and its variant, return on incremental invested capital (ROIIC), act as important guideposts to help managers make decisions regarding the use of the company’s cash flow and existing resources. 

When a company is managed for profitability rather than just profits, it focuses on the value created or destroyed by operating and allocation decisions.