Return on invested capital: Is this metric in your company's toolkit?

April 13, 2022

By Steve Campana, CPA, ABV, CFF^®
Partner

When considering the financial health of your business, the first instinct is most likely to look at the income statement or the "bottom line." If the results do not meet your expectations, the next move is often cutting overhead in the form of general and administrative expenses.

This can be problematic as it ignores opportunities to improve cash flows and net income through managing your company's balance sheet.

A method frequently overlooked when assessing strategies to improve a company's financial performance is focusing on its return on invested capital (ROIC). ROIC determines how efficiently a company uses its invested capital (equity plus interest-bearing debt, plus obligations under capital leases¹) to generate profits and cash flows.

The ratio is calculated by taking net operating profit after pro forma² taxes (NOPAT) and dividing it by the company's average invested capital. Using ROIC helps a company focus on both the income statement and the balance sheet, providing a well-rounded approach to improving company cash flows and overall financial health.

Return on Invested Capital = (Net Operating Profit After Pro Forma Taxes (NOPAT)/(Average Invested Capital)

The formula indicates that to increase a company's ROIC, NOPAT (the numerator) needs to increase, or the average invested capital retained in the business (the denominator) needs to decrease. The following illustration demonstrates the impact of implementing two NOPAT (income statement) strategies and two invested capital (balance sheet) strategies on a sample company's ROIC.

The improvement strategies will include:

• Improve gross margins.
• Reduce selling, general and administrative expenses.
• Decrease the number of days sales in accounts receivable.
• Increase inventory turnover.

For this illustration the sample company has fully borrowed against its line of credit with a borrowing base of 75% of eligible accounts receivable and 40% of inventories. Additionally, they are collecting accounts receivable in 60 days, turning over inventory 4 times per year and paying trade accounts payable in 30 days.

On the income statement side, the sample company has revenues of $25,000,000, gross margins of 30%, selling, general and administrative expenses of 22% of revenues and the pro-forma tax rate is 30%.

Exhibits 1.1 and 1.2 demonstrate the effects of implementing the ROIC improvement strategies individually along with the impact of using them in combination with one another. Each method significantly helps improve upon the sample company's ROIC, and when successfully applying all the suggested strategies, they see a 17.29% increase in ROIC and an increase in cash flow of $4,228,000.³

It is important to note that based on the assumptions in this example:

• The changes resulting from better management of the balance sheet alone increased ROIC by 8.45%
• The improvements made by increasing gross margins and reducing expenses alone increased ROIC by 5.63%

Exhibit 1.3 displays the financial benchmarks of the sample company before and after the focus shifted to increasing ROIC as well as compared to the sample company's industry standard, thus illustrating the benefits of increasing ROIC.

Besides the one seen in exhibit 1.3, there are many other benefits that result from having a high ROIC. Mercer Capital published an article in 2019 outlining five reasons a business should focus on ROIC. They stated that companies with a high ROIC often:

• Grow faster.
• Distribute more cash.
• Have less risk.
• Provide better returns.
• Are worth more in the long run.

(Source: Five Reasons Your Family Business Should Focus on ROIC)

Having high ROIC might not only improve your company's financial return but also gives your company a competitive advantage in the marketplace and provides a more comprehensive means to check the overall health of the company. The next time you are looking to boost your company's financial health, besides just looking toward the income statement for improvements, consider focusing on increasing ROIC and reaping the many benefits that stem from generating a higher ROIC.

For more exhibits related to this column, visit: www.honkamp.com/wp-content/uploads/2022/03/Complete_Exhibits.pdf

1. Note in the realm of traditional corporate finance and publicly traded companies' cash and cash equivalents are generally deducted to arrive at net, invested capital. In the world of small to medium sized privately held enterprises it is the authors opinion that cash and cash equivalents would only be deducted to the extent that company has excess working capital. Perhaps the subject of a future article.
2. Provisions for taxes calculated on operation income.
3. In this example, increases in cash flows were used to pay down the company's line of credit. The same would hold true for a company with nominal debt in that the excess cash flows not required to be retained in the business can and generally should be distributed to the owners of the enterprise.