Prateeksha Sabhani - Team MoneyWorks4meThe Debt Factor – ROIC
Why should you look at a company’s ROIC?
Let s start with first answering what is ROIC?
ROIC is a financial measure that quantifies how well a company generates cash flows relative to the capital it has invested in the business. Here, the investment represents pool of funds supplied by its shareholders & the lenders.
ROIC – Earnings before Interest & Depreciation/ Total Capital
Let’s see what does Total Capital mean??
Total Capital = Equity Capital + Debt Capital
Equity Capital:
Equity Capital is the money contributed by the promoters and the other shareholders. Equity holders are basically the owners of the company.
Debt Capital:
Debt Capital is the money borrowed from banks/ other lenders carrying an interest charge on it.
Hence, the total capital of the firm is the sum of this equity capital + debt capital.
Now, why are we stressing on ROIC here??
ROIC is a true measure of the company’s returns and gives a fair picture of the profitability as it includes the debt component. Companies can raise a lot of debt to increase their ROE (return only on the equity capital excluding debt); hence showing a rosier picture of the return, but the main factor that needs to be taken into consideration is the Debt.
Let’s look at an example:
Mr. A invests Rs 3 Crore in a portfolio of stocks, out of which he invests only 1 Crore of his own & raised the rest through debt from banks at 12% interest charge. In the next year the value of his portfolio appreciated to Rs.3.60 Crore. His return hence is, (60 lakhs less 24 Lakhs for -interest charge) = 36Lakhs. If we look at his ROE it is 36%, (i.e. 36 laks on Rs.1Crore) but if you look at his ROIC taking the debt factor into consideration it is 20%.
Hence while investing in a company, watch out for companies having a high debt. Due to its capital structure being highly leveraged(high debt) its ROIC is very low.
Hence, while looking at a company’s returns & its capability to generate further returns we must give stress on its ROIC figure as well which shows a fairer picture of the company’s capability.
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Yog Rajani
Ketan Pitrubhakta
Sorry, I think ROIC = Net Operating Profit After Taxes / Total Capital. If you take EBIDA / Total Capital you might be overestimating ROIC because you are not considering the depreciation and amortization. Regards.
Sorry, I think ROIC = Net Operating Profit After Taxes / Total Capital. If you take EBIDA / Total Capital you might be overestimating ROIC because you are not considering the depreciation and amortization. Regards.
NOPAT what you talk about is EBIT (1-T), so that also doesn’t take the interest cost into consideration. While calculating ROIC in most of the cases for the numerator the interest & depreciation cost are added back(or Earnings before Interest & Dep cost). There are a few different formulas to calculate ROIC. Those are
1) EBIT(1-T)/ Total Capital
2) EBIT/ Total Capital
3) EBITDA/Total Capital
4) EBIDA/Total Capital
NOPAT what you talk about is EBIT (1-T), so that also doesn’t take the interest cost into consideration. While calculating ROIC in most of the cases for the numerator the interest & depreciation cost are added back(or Earnings before Interest & Dep cost). There are a few different formulas to calculate ROIC. Those are
1) EBIT(1-T)/ Total Capital
2) EBIT/ Total Capital
3) EBITDA/Total Capital
4) EBIDA/Total Capital