ROIC: Tax and Accounting New Hot Topic



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ROIC-New-Hot-Topic Return on Invested Capital (ROIC) is a financial profitability ratio that measures how efficiently a company generates cash flow from the capital that is invested in it. The formula divides an estimated measure of cash flow – typically Net Operating Profit After Tax (NOPAT) – by a company’s equity and debt minus its cash; a measure of how much capital stock has been invested. The ROIC metric has become an important calculation for a variety of users, including accounting and tax professionals as well as investors.

Accounting and tax professionals need to understand the increasing popularity of the ROIC metric. For example, accountants will find the calculation useful since their clients will want to assess how their respective ROIC ratios compare to those of industry peers. Tax professionals should appreciate the mathematics behind the ROIC calculation since it is a financial measure that reflects tax planning results.

From the perspective of an investor, the higher the ROIC – the better a company is at increasing its operating profits for every dollar that is invested in it. If investors do not earn the realized return they had expected, they will seek to sell the asset.

Analyzing ROIC

ROIC is a popular financial metric utilized for evaluating companies in various industries.

The following companies, taken from a sampling on TheStreet.com, are above median relative to industry peers when observing ROIC rates:



Weighted Average Cost of Capital (WACC) calculates the presumed rate to be paid to all security holders for financing assets. For example, if ROIC is greater than WACC, the difference in percentage indicates that the company is generating more in profits than it costs to continue business operations.

United Continental Holdings (UAL) is a leading airline company in the U.S. Their ROIC rate of 56.25% shows that, based on the cost of capital, UAL is very efficient at earning operating income from invested dollars.

Furthermore, Brinker International (EAT), which owns Chili’s and Manggiano’s Little Italy restaurant chains, has a ROIC of 29.50%, which is high for the restaurant industry.

Finally, HCA Holdings (HCA), a leading hospital chain operator, has a ROIC of 19.04%. While this percentage is certainly lower than those of both UAL and EAT, this ROIC rate is still very high for the industry.  

In analyzing the above examples, it is clear that different industries call for differing levels of financing. For example, an airline company having a higher WACC than a restaurant chain shows that investors require a higher rate of return on invested capital for the airline industry than they do for the restaurant industry. This is due to the fact that airline companies invest capital much more intensively than companies in other industries that use fewer capital assets. If a company’s cost of capital is higher, the return will be higher from every invested dollar that is expected, leading to a higher expectation for wealth creation.  

When a company has a high ROIC rate, this does not necessarily mean that it is better managed than one with a lower rate. However, a company that shows a steadily increasing rate of ROIC over time indicates a positive trend for business performance.

Conclusion

ROIC is becoming an important metric when looking at a company’s ability to turnover an invested dollar directly from core business operations. Business advisors that recognize the merits of this will be able to better serve their clients. Similarly, investors that pay attention to ROIC will have a better understanding of a company’s profitability and wealth creation ability. Even if a particular company currently has a low ROIC, a positively up-trending ROIC is a favorable sign. As more companies use the ROIC metric, the advisory community needs to understand the essence of the calculation.

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Authors

Tricia Genova is a Tax Analyst with R&D Tax Savers.

Robert Goulding is a CFA and Investment Professional with R&D Tax Savers