When analyzing the financial indicators of an investment project, determining the profitability of the investment is considered an extremely important step. The entire investment plan is built on the basis of this indicator, and finding a parameter that can reveal the efficiency of resource sales is the most important stage of the entire process. For these purposes, the return on investment capital ratio is used.
In this article we will look at the concept of return on invested capital and learn how this economic indicator is correctly calculated.
What is considered investment capital
In a simplified sense, investment capital means the amount of money invested in a project (production or provision of services) in order to make a profit. By the nature of origin, investment capital can be divided into equity and borrowed capital.
Own investment capital is usually understood as the volume of net profit aimed at implementing investment projects. Borrowed capital includes financial liabilities, the attraction of which is associated with the alienation of part of the profit at the end of the term.
In the first case, everything is more or less clear. Funds received from activities are partially or fully allocated to expand or modernize production in order to obtain greater profits. In the case of borrowed capital, there is both a bank or other loan and the attraction of a new owner with the subsequent purchase of his share.
In this regard, one more type of investment capital should be considered - attracted, which differs in that its implementation is associated with a change in the structure of the company's owners. In other words, capital raised is considered as such when the entry of a new owner takes place in parallel with an increase in investment. This process is associated with a decrease in the share of the original owner due to the alienation of part of the shares in favor of a new participant in exchange for his cash injections.
In its structure, investment capital consists of:
- tangible assets (land plots, real estate, direct investments, etc.);
- financial assets (shares in another company, shares and debt bonds);
- intangible assets (increasing market share, conducting marketing analysis or other)
It is important to note that investment capital is considered such if it is invested only in the main activity. The same condition applies to profit. However, some experts use general data to simplify calculations. In this case, a discrepancy may be observed, the size of which is directly related to the volume of investment in various areas of activity.
Thus, we see that investment capital can have many forms and ways of implementation, but its goal remains the same - obtaining additional profit. In view of this, economists introduced an indicator. Which allows you to determine how efficiently assets are used.
What is return on investment capital
Profitability in economics is considered to be a relative indicator of efficiency. It is a kind of efficiency factor in the context of production or service provision. In other words, high-quality sales of labor, money and other resources should lead to increased profitability.
In the field of investment, profitability indicator occupies a central place. Attracting your own or borrowed assets is directly related to the desire to receive a return in the form of increasing your market share, increasing financial stability or developing a free niche.
The return on investment capital indicator is usually designated ROIC (Return of Invested Capital). It is part of a larger category called "Profitability Indicators", which combines the efficiency of use:
- shareholders' equity (ROCE);
- total assets (ROTA);
- gross (GPM) and operating (OPM) profit
The basic formula for finding the return on investment capital indicator:
NOPLAT/Investment capital
NOPLAT is a reflection of net operating income minus applicable taxes and dividends.
Practice shows that most specialists use a simplified approach to calculating ROIC, which considers the entire activity of the enterprise without dividing into core and other activities.
In this case, the appearance of an error in the calculations is inevitable, and its size is determined by the share of investments in non-core activities. Thus, the formula for finding the return on investment capital takes the following form:
ROIC=EBIT(1 – Tax rate)/Investment capital
EBIT (Earnings before interest and taxes) means profit before taxes and dividends.
All parameters are taken according to the average annual value, that is, the indicators at the beginning and end of the year are added up and divided in half. ROIC is often called the Return on Total Capital Indicator, meaning that from the moment of investment, assets become part of the total capital.
It is worth noting that the result of the calculations should be a percentage indicator that is compared with the planned one. Based on this operation, the feasibility of further investments is determined.
Purpose of the profitability indicator
As mentioned earlier, return on investment capital is one of the most important indicators of the economic efficiency of an enterprise. It shows the return on investments made, and on its basis the need for further injections is formed.
It should be noted that calculating the ROI before investing allows you to determine the feasibility of the initial investment. To more fully understand the current state of affairs at an enterprise, economists often use this indicator to find an answer to the question: is investment required at all? In other words, comparing the ROI indicator with the planned one allows you to determine whether it is worth increasing the amount of investment at all, albeit at the expense of your own funds.
Separately, it is worth mentioning such a parameter as the payback period. This indicator is closely related to profitability itself and has a direct impact on it. Each investment project has a return period - the amount of time required to receive the planned income. This indicator depends on a number of variable factors, including both macroeconomic indicators and specific features of the selected industry.
And the impact of return on investment capital must be considered inextricably from the payback period. A qualitative analysis of ROIC requires the construction of an investment plan taking into account many related indicators, for example, finding a break-even point or behavior in the event of financial force majeure.
Advantages and disadvantages
Among the obvious advantages of using the return on investment capital parameter, it is worth noting the simplicity of its calculation. As can be seen from the formulas, to obtain a result, knowledge about the amount of profit and the amount of investment are required.
Thanks to this simple formula, it is possible to determine the level of efficiency in the use of tangible and intangible assets. But this is also where its main drawback lies. Application of the formula in its initial form leads to an increase in the level of error, which, when running a large business, leads to the receipt of incorrect data, which in turn are variables in other calculations.
In other words, to determine the most accurate indicator of return on investment capital, a more detailed formula is required that would take into account a wider range of financial actions.
However, for a small business segment or within the framework of an insignificant project, such a simplified determination of the efficiency parameter should definitely be considered an advantage.
Despite the information content of the result obtained, the profitability indicator has a number of significant drawbacks that make it difficult to use.
- Impossibility of establishing the nature of the origin of income. The usual calculation formula does not allow one to determine how much income was received from operating activities, how much is part of permanent profit, and how much can be considered one-time;
- Possible manipulation of results by management. This minus directly follows from the previous one. Due to the wide variability of data and ambiguity in formulation, the use of ROI may allow stakeholders to substitute data;
- High level of dependence on external economic factors, such as inflation and the US dollar exchange rate. This point cannot be considered a drawback of only this parameter, since changes in the economic indicators of the state are the reason for changing the methods for determining efficiency, but the connection between these factors should not be denied.
Conclusion
The return on investment capital indicator is very common, as it gives a completely understandable picture of the efficiency of using an enterprise's resources. However, its use is associated with a large number of errors that do not allow its use everywhere.
One way or another, the ROI indicator is changing, taking on other forms and taking into account more and more indicators. One way or another, the return on investment capital indicator is one of the most basic ways to assess the effectiveness of financial investments.
The main criterion for assessing the performance of any commercial organization is profitability ratios. Next, we will consider the methodology for calculating these indicators.
Return on Capital Employed (ROCE)
The ratio is calculated as the ratio of net profit minus dividends on preferred shares to ordinary share capital. The formula for calculating the indicator is as follows:
ROCE = Earnings before interest and tax (EBIT) / Capital employed
ROCE = (Net profit - Dividends on preferred shares) / Annual average common share capital
The average annual value of assets is calculated on the basis of the enterprise's balance sheet as half the sum of the value of assets at the beginning and end of the year or as the arithmetic average of the balance sheet values at the end of the quarters included in the reporting year.
The Return on capital employed indicator is used by financiers as a measure of the profitability that a company generates on its invested capital. This is usually necessary to compare the performance of different types of businesses and to assess whether the company generates enough profits to justify the cost of raising capital.
If the company does not have preferred shares and is not obligated to pay dividends, then the value of this indicator is equivalent to Return on equity (ROE).
Return on Invested Capital (ROIC)
This ratio is calculated as the ratio of the company's net operating profit to the average annual total invested capital. The formula for calculating the indicator is as follows:
ROIC = (Net operating profit - adjusted taxes) / Invested capital
ROIC = NOPLAT / Invested capital * 100%
where, NOPLAT is net operating income less adjusted taxes.
Invested capital is capital invested in the main activities of the company. Only capital invested in the company's main activities should be counted as invested capital, just as the profit considered is profit from the main activities. In general terms, invested capital can be calculated as the sum of current assets in core activities, net fixed assets and net other assets (less non-interest bearing liabilities). Another calculation option is that invested funds are considered the sum of equity capital and long-term liabilities. The details of determining the amount of capital invested will depend on the accounting practices and business structure.
The main condition that must be achieved is that the analysis must take into account that and only that capital that was used to obtain the profit included in the calculation. In practice, they often resort to a simplified approach, in which the main activities of the company are not highlighted, and the analysis is carried out on all investments and all income. The error of this assumption will depend on what the company’s non-operating profit will be in the period under review and how large the investment in non-core activities will be. Taking into account possible assumptions, the ROIC formula can be written in other forms:
ROIC = ((Net Income + Interest * (1 - Tax Rate)) / (Long-term loans + Equity)) * 100%
ROIC = (EBIT * (1 - Tax rate) / (Long-term loans + Equity)) * 100%
Indicators of the amount of investment are taken according to the average annual value (defined as the amount at the beginning and end of the year, divided in half). In all cases, the calculation of this ratio assumes the use of data from annual profit and loss reports. If quarterly or other reporting is used in the calculation, the coefficient must be multiplied by the number of reporting periods in the year.
Return on Total Assets (ROTA)
Return on total assets (ROTA) is usually calculated as the ratio of net profit to average assets. The advantages of using this ratio are clear: maximizing ROTA forces managers to increase revenue, reduce costs and non-productive expenses (attributable to profit), and reduce the value of assets (by getting rid of non-productive assets, reducing accounts receivable and payable). Calculated using the formula:
ROTA = EBIT / Total net assets
ROTA = EBIT / Enterprise assets
where EBIT is profit minus taxes and interest (operating profit).
The ROTA indicator is similar with the only difference that when calculating ROTA, operating profit is used rather than net profit.
One of the invisible but significant disadvantages of ROTA at first glance is the deterioration of this indicator as a result of attracting borrowed capital. In addition, focusing on this indicator does not contribute to optimizing the structure of assets and does not take into account the seasonal specifics of a particular type of activity.
The ROTA indicator is especially useful to use as an additional indicator to compare the efficiency of using the assets of holdings with a diverse range or vertical integration. In this case, it is possible to assess whether investments in a given asset (machines, premises, stocks of raw materials in a warehouse) for the production of certain products bring the required return, and to form an optimal set of assets for the production of the optimal assortment.
Gross Margin Ratio (GPM)
Another name for this ratio is Gross margin ratio. Demonstrates the share of gross profit in the company's sales volume. Calculated using the formula:
GPM = Gross profit / Revenue
GPM = (Revenue - cost of goods sold) / Revenue
GPM = Gross Profit / Total Revenue
The calculation is made for different periods of time, using the total values for the period.
Operating profit margin (OPM)
The indicator shows the share of operating profit in sales volume. Calculated using the formula:
OPM = Operating income / Revenue
OPM = Operating profit / Total revenue
Net profit margin (NPM)
Demonstrates the share of net profit in sales volume. Calculated using the formula:
NPM = Net income / Revenue
NPM = Net Profit / Total Revenue
Coefficients assessing the return on capital invested in an enterprise. The calculation is made for an annual period using the average value of the corresponding items of assets and liabilities. For calculations for a period of less than one year, the profit value is multiplied by the appropriate coefficient (12, 4, 2), and the average value of current assets for the period is used. To obtain percentage values, as in previous cases, it is necessary to multiply the coefficient value by 100%.
Return on Net Assets (RONA)
Return on net assets demonstrates the ratio of net profit to the average annual value of non-current assets and net working capital.
RONA = Net income / (Fixed assets + (Current assets - Current liabilities))
RONA = Net Profit / Net Assets
For industrial enterprises, the formula for calculating return on net assets will be as follows:
RONA = (Plant revenue - Сosts) / Net assets
The calculation of return on net assets is similar to the calculation of return on assets (ROA), but unlike RОА, RONA does not take into account the company's associated liabilities.
Note that the profitability indicator does not directly evaluate capital expenditures; RONA reminds managers that there are costs for acquiring and maintaining assets.
Return on Current Assets (RCA)
The RCA indicator demonstrates the company's ability to provide a sufficient amount of profit in relation to the company's working capital used. The higher the value of this ratio, the more efficiently working capital is used. Calculated using the formula:
RCA = Net income / Current assets
RCA = Net Profit / Working Capital
Return on Fixed Assets (RFA)
This profitability ratio demonstrates the company’s ability to provide a sufficient amount of profit in relation to the company’s fixed assets. The higher the value of this ratio, the more efficiently fixed assets are used. Calculated using the formula:
RFA = Net income / Fixed assets
RFA = Net profit / Non-current assets
The basic decision-making model when investing capital in a new or existing project is based on how much benefit the entrepreneur will receive and when. In educational and academic literature one can find many different methods for calculating the efficiency of investment capital, but most of them are hardly suitable for use in practice due to their complexity, operating with extensive statistical data, etc.
This article will discuss the main methods for assessing the return on invested capital, which are quite widely used in practice and working with which does not cause difficulties even for an entrepreneur who is not experienced in econometrics.
Basic models for calculating company value and return on investment in business
As you know, the value of a business (a separate company or a holding) is determined by its ability to produce a positive cash flow (financial result) in a specific period of time. This ability is largely determined by the extent to which the existing business model has the ability to reproduce the capital invested in it and generate additional profit.
There are several basic models used to assess the effectiveness of a company's investments, which can be presented as follows:
- Business discounted cash flow model
- Economic profit model
These two main models are most widely used in practice, and they are included in the curricula of almost all universities where there are economic disciplines. For example, the discounted value method most clearly shows how much the company's generated profit is sufficient to cover all costs and expenses of investments.
In addition to these two defining models, there is also a method for calculating return on investment used for specific types of business:
- Adjusted present value model— used to assess the return on investment of companies that have a flexible cost structure (for example, companies built on the principle of a holding company or operating as a network project).
- Cash flow model for shares (share in authorized capital)— is intended mainly for companies with a joint-stock capital structure, working with client portfolios, banks and insurance companies.
Methodology for using basic models to evaluate ROI
The discounted cash flow model for a business enterprise uses a company's cost of equity, which is defined as the valuation of its core business minus debt obligations and other legal payments to investors (such as payments on bonds or preferred stock). The cost of operating activities (operating cost) and the cost of debt equal the corresponding cash flows discounted at rates that reflect the risks associated with the business.
This model is mainly used to evaluate companies that have one type of business as a single entity. To use it in cases where a company consists of several subsidiaries, one should resort to an assessment of each individual structure plus the costs of overall corporate governance.
The value at the end of a particular forecast period can be estimated using the extended value formula:
Where:
- NOPLAT− net operating profit less adjusted taxes (in the first year after the end of the forecast period);
- ROIC− incremental profitability of new invested capital;
- WACC− weighted average capital costs;
- g− expected growth rate of NOPLAT in the indefinite future
The key elements in this model appear to be:
- Return on invested capital (return on invested capital ratio)
- Weighted average cost of capital.
Return on invested capital is determined in a relatively simple way, which can be expressed by the following expression:
Where:
- NOPLAT is net operating profit adjusted for taxes and mandatory payments.
- Invested capital is operating working capital + net fixed assets + other assets necessary to implement the investment project.
Return on invested capital shows how the investor's invested assets are capable of bringing him profit, the level of which, at a minimum, should not be lower than the inflation rate (or the interest rate if the investment is made on margin terms, i.e. in debt).
In order for this coefficient to always be greater than 1 (one), it is necessary for the investor to comply with a number of conditions or adhere to a certain set of funds that have the ability to increase the return on invested capital.
Such methods could, for example, be:
- increase the level of profit that a business receives from capital already invested (i.e., increase the return on capital invested in existing assets);
- ensure that the profitability of any new investment exceeds the weighted average cost of capital or, in other words, the break-even point of each subsequent business should be higher than the previous one;
- accelerate growth rates, but only as long as the return on new investments exceeds the weighted average cost of capital, i.e. using economies of scale in production until costs begin to exceed a certain optimal level of costs;
- reduce capital costs by minimizing costs, tax optimization, using new technologies, etc.
This simple method for calculating the effectiveness of investments both in an existing business and in a completely new project cannot cover the specifics of each individual type of business activity. Therefore, there are many industry-specific or detailed methodologies for calculating ROI, such as the method used for accounting purposes on a company's balance sheet.
Methodology for calculating return on investment according to IFRS standards
Since many Russian companies have close ties with foreign counterparties, and many are simply integrated into international corporations, it makes sense to consider a model for assessing return on investment, used according to the uniform standards of developed countries. At its core, this is a factor analysis of return on invested capital, where the main elements are considered assets taken into account in the balance sheet of companies, as presented in the following diagram:
The already familiar formula for the return on investment ratio has the same form, but with a more expanded consideration of factors influencing the final performance indicators of the invested capital:
Where the main elements of NOPAT (operating profit before taxes) and IC (invested capital) are presented in a more detailed form, or the so-called “balance sheet formula”: “NOPAT”
Where:
- EBIT – earnings before interest and taxes;
- IL – interest payments on leasing (Implied interest expense on operating leases);
- ILIFO – increase compared to the purchase price of inventories accounted for using the LIFO method (Increase in LIFO reserve);
- GA – goodwill amortization;
- BD – increase in bad debt reserve;
- RD – increase in long-term R&D costs (Increase in net capitalized research and development);
- TAX – the amount of taxes, including income tax (Cash operating taxes).
"IC" (invested capital)
Where:
- BV – book value of common shares (Book value of common equity) or authorized capital;
- PS – preferred shares (Preferred stock);
- MI – Minority interest
- DTAX - Deferred income tax reserve
- RLIFO – LIFO reserves
- AGA - Accumulated goodwill amortization - intangible assets
- STD – short-term debt on which interest is charged (Interest-bearing short-term debt)
- LTD – long-term debt capital
- CLO – capitalized lease obligations
- NCL – present value of non capitalized leases
As a conclusion to this article, we can conclude that the presented models for assessing the effectiveness of investments reflect a fairly general approach. But, nevertheless, an idea of how the elements of a business model affect the final result will help many novice investors or entrepreneurs correctly assess all the factors that determine the ultimate success of investing.
Characterizes the return on the amount of money invested in the business.
Return on invested capital calculated in the FinEkAnalysis program in the Analysis and assessment of profitability and profitability block as Return on invested capital..
Return on invested capital - what it shows
Return on invested capital shows how effectively the management of the enterprise invests funds in the core activities of the enterprise.
Return on Invested Capital - Formula
General formula for calculating the coefficient:
Calculation formula based on balance sheet data:
| K rick = | p.2400 Form 2 |
| (p.1300n. Form 1 + p.1300k. Form 1 + p.1400n. Form 1 + p.1400k. Form 1 + p.1530n. Form 1 + p.1530k. Form 1)/2 |
Return on invested capital - value
The higher the indicator Return on invested capital, all the better.
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Return on investment on capital employed is determined in several ways, depending on the basis of measurement. Capital can be invested in the real sector of the economy or in the financial sector.
Estimation of return on investment on invested capital in the real sector of the economy
Many investors simultaneously invest in assets of the real sector of the economy and financial instruments. The following indicators are used to analyze the profitability of such investments:
- Return on investment (ROI);
- Return on invested capital (ROIC).
The return on investment ratio shows the return on capital invested in a business at the current moment and is regularly assessed during the activity of the invested object.
It is defined as the ratio of the difference in income minus production costs to the total investment in the business as a percentage.
- P - gross income from investments;
- СF - production and circulation costs;
- I - full investment in business.
Total investment in a business includes equity capital and long-term liabilities of the investee:
Where:
- Wc - equity capital;
- Wr - long-term liabilities.
This indicator reflects the effectiveness of investment capital management, by which the investor evaluates the work of the management of the invested object. A positive assessment of activity occurs when ROI > 100%, this means that the investment has paid off and is making a profit. The size of this profit and the dynamics of its change serve as an assessment of the company’s performance.
For example:
- The equity capital of the invested object is 12.5 million rubles and 14 million rubles at the beginning and end of the year.
- Long-term liabilities, respectively: 2.5 and 4 million rubles.
- Gross income at the beginning and end of the year was: 65 million rubles and 78 million rubles.
- Production costs, respectively: 44 and 51 million rubles.
Then ROI in accordance with formula (1), at the beginning and end of the year will be: 40% and 50%, i.e. the return on investment ratio increased by 10%, which indicates the high efficiency of the company's management.
Another indicator of return on investment on invested capital is the ROIC (Return On Invested Capital) indicator - translated from English as “return on invested capital”, and in fact, return on invested capital.
It is defined as the ratio of net profit to invested capital in the main activity of the investee.
- NOPLAT - net profit, net of dividend payments;
- Invested Capital - capital invested in core activities.
In Russian economic terminology, this is an indicator of return on investment, but only those invested in core activities, that is, return on investment in fixed capital. Fixed capital in this case means fixed assets plus net other assets with the amount of working capital for core activities. A prerequisite for calculating this indicator is that the calculation takes into account the net profit created only by the capital that is in the denominator of this indicator. Sometimes, in case of difficulties with isolating the fixed capital from the total cost of capital and determining the profit created by it, they resort to a simplified calculation, dividing the entire profit by the cost of capital. If the size of non-fixed assets is small, then the error of the indicator will be small and acceptable for analysis, but if this is not the case, then such an indicator cannot be trusted.
This indicator demonstrates to the investor the ability of the management of the invested object to generate added value in comparison with other investable objects of the investor. For such assessments, a certain standard is used - the rate of return on investment in a competitive environment.
The rate of return on an investment is the ratio of the income received to the investment that generated that income, as a percentage, over a specific period of time.
For example, an investor has three investable objects:
- 1 object at the beginning of the year received a net profit of 32 million rubles, and at the end of the year 43 million rubles, with invested capital of 30 and 40 million rubles, respectively;
- 2 object at the beginning of the year received a net profit of 50 million rubles, and at the end of the year 53 million rubles, with invested capital of 45 and 49 million rubles, respectively;
- 3 object at the beginning of the year received a net profit of 12 million rubles, and at the end of the year 13 million rubles, with invested capital of 6 and 8 million rubles, respectively.
Accordingly, ROIC at the beginning and end of the year:
- for 1 object 106.7% and 107.5%;
- for 2 objects 111% and 108%;
- for 3 objects 150% and 162.5%.
Accordingly, the rate of income is:
- for 1 object 107.5 - 106.7 = 0.8%;
- for 2 objects 108 - 111 = -3%;
- for 3 objects 162.5 - 150 = 12.5%.
If the investor considers the minimum acceptable rate of return on 1 ruble of investment equal to 10%, then 1 and 2 investment objects do not meet this requirement and the reasons for such a low return on investment must be analyzed, and for the second object an additional analysis of the decrease in return on investment is necessary. If it is impossible to increase the profitability of investment objects 1 and 2, the investor raises the question of closing the investment project.
If the analysis of investment profitability is carried out over several years, then the cash flows are discounted at the time of the profitability analysis at the discount rate accepted by the investor.
The disadvantage of this indicator is that management is focused on “squeezing” profit from investments in any way at the current moment, which can lead to a lag in updating production and ultimately lead to a loss of competitiveness of the company.
Estimation of return on investment on invested capital in financial instruments
The return on investment on invested capital in financial assets consists of current and capitalized components.
Current income is defined as the difference between the sale price received at the end of the investment period and the purchase price of the security.
I = St - So
- I - current investment income;
- So is the purchase price of the security;
- St - income received at the end of the period (year).
For example, an investor purchased 10 shares at a price of 1,000 rubles at the beginning of the year, and at the end his income from the sale of shares amounted to 11,500 rubles. In this case = 11,500 - 10,000 = 1,500 rubles.
The ratio of current income to investments made is called the capital gains rate or interest rate and is expressed by the following formula:
Where rt is the interest rate, and for this investment it is 15%.
Another indicator for assessing the return on invested financial capital is called the relative discount. It is defined as the ratio of current income to income at the end of the period:
Or for our example: dt = 1500 / 11,500 * 100 = 13%.
This indicator is also called the discount factor. The interest rate is always greater than the relative discount.
Total return reflects the increase in invested capital over a specified period, taking into account the redemption of the security.
The main indicator used in total return analysis is yield to maturity indicator YTM, which is akin to the internal rate of return on investments (IRR), is the average effective interest rate at which the value of all income received is discounted to the value of the initial investment. Like IRR, this indicator is quite complex to calculate, but below is a simplified formula for calculating this indicator:
- YTM - yield to maturity;
- CF - flow of current income from investments;
- Io - initial investment;
- n - number of periods;
- N - payment to the investor at the end of the period.
For example, 10 shares purchased for 10,000 rubles bring annual income:
- CF = 1500 rubles per year;
- Io = 10,000 rubles;
The capitalization of 10 shares by the end of 3 years amounted to 1,500 rubles:
- N = 11,500 rubles;
- n = 3 years.
YTM = 4500+(11500-10000)/3/(11500+10000)/2= 46.5%
It is obvious that the yield to maturity is significantly higher than the interest rate, which allows us to assert the feasibility of these investments in a financial instrument.