How to Decide: Return on Invested Capital
How does your management team measure success, evaluate investment decisions consider its performance, allocate its capital, align incentives, and create value? If you are not evaluating these parameters you are lacking the comprehensive insight in how effectively your company is using its capital to generate profits. Introducing or improving a crucial financial metric of return on invested capital (ROIC) is what you need.
Return on invested capital is a measure of company’s operating efficiency, or operating income less taxes expressed as percentage of invested capital of the company.
Return on invested capital is important because it provides comprehensive insight into how effectively a company is using its capital to generate profits:
Efficiency and Profitability: How efficient is a company in converting the money invested in the business into profits.
Investment Decisions: Investors use ROIC to compare the performance of similar companies. It helps in determining which companies are more attractive investment opportunities.
Performance Benchmarking: Provides a benchmark to evaluate the performance of a company against its competitors. This should influence management decisions, strategic planning, and operations.
Capital Allocation: ROIC is critical for managers in making capital allocation decisions. It should be used to decide where to invest the company’s resources, e.g., new projects/products, expansion, acquisitions, to create value.
Incentive Alignment: ROIC is often linked to executive compensation thereby aligning the interests of managers with shareholders.
Value Creation: ROIC helps assess whether a company is generating return above its cost of capital. If a company’s ROIC is higher than its weighted average cost of capital (WACC), it is creating value.
Are you evaluating your capital allocation consistently and making the appropriate investment decision?
Reach out if you want to discuss transforming your strategic planning and investment allocation by using a fact-based and value creating approach.