ROIC is a widely misunderstood metric. When examining or calculating ROIC it’s important to consider the context behind the face-value figure to ensure a clear understanding of what is included in ‘invested capital’ – and how that’s understood in the context of a business’s expenditure and returns.
In this article, we explain what an ROIC figure can tell you, when positive or negative ROIC figures can be useful, and – importantly – how a business can improve its ROIC.
In this article:
What is ROIC?
ROIC stands for Return on Invested Capital, and it’s calculated by dividing net operating profit after tax by invested capital. This delivers a figure, expressed as a percentage, that can be used to understand how a business is performing.
ROIC is a more useful metric in industries with high capital needs, such as those with brick-and-mortar outlets, or major infrastructure requirements. These industries require large-scale capital outlay and investment decisions can drive the success – or otherwise – of the business.
Generally, a business that is creating more than 2% ROIC is seen as delivering value, and is therefore likely to be a good investment.
However, there are different ways to calculate invested capital, so analysing a business’s ROIC could require more work than simply using basic, top-line figures.
What does ROIC tell us about a company?
ROIC, at its most basic, tells us how a company is performing. But it needs to be assessed correctly and the underlying calculation needs to take into account all money spent, and profits delivered.
For a business, the allocation of funds for investment is an important decision. Investments are generally made on the understanding they will deliver more in return than the original money spent. Otherwise, they are simply a sunk cost.
There are different ways in which a business can calculate its investment capital. It can consider its total assets then take away its cash and liabilities. This would include liabilities that are not earning interest or other cash benefits.
Or, a business can consider its equity and assets against the value of its debt.
The calculations done are important because they detail, for a consultant, advisor, or other third party considering the company’s health, whether the business is using its investment funds well. In turn, this reflects how a business is run, the likelihood of its ongoing success, and investments that will be needed in the future.
While it can be a complex metric to calculate, those who are able to do so – and assess the data behind the output figure – will likely make better investment decisions both for themselves and clients they are advising. An understanding of ROIC also allows investors to find and make early investments in companies that are set to perform well over time.
According to this article from Zürcher Kantonalbank, for example, some companies ultimately achieve ROIC of 20% or even more. At this level, the company is showing it is investing very wisely and returns are excellent. It is generating high levels of value and is likely to have a competitive advantage in the market.
How does ROIC compare to growth?
Growth and ROIC are both important metrics for business leaders to consider, and balancing the two can be a difficult process. As this McKinsey note points out, executives often struggle to balance growth and returns. High returns on capital can be a chance to invest for growth, but investment decisions can be difficult, particularly when they undercut impressive profit figures.
On the flip side, companies with low returns can find themselves in a rut of trying to increase growth instead of investing in long-term success.
The most important analysis is to consider ROIC through the lens of the business’s growth strategy and its historic context.
Low vs high ROIC
A low or even negative ROIC is acceptable – even beneficial – if there is a clear plan toward using the investments for expansion and growth. For example, large purchases of machinery or other equipment designed to make the business more efficient over time may drive down the ROIC, but with a positive long-term ambition.
A high ROIC will generally be regarded in a positive light, and rightly so. A healthy ROIC generates cash for the company to invest, thus setting it up for further growth and success.
However, if the ROIC is high but has been dropping, that may be a warning that the business is not investing wisely or with enough analysis of returns on the funds spent.
As such, analysis of ROIC should be nuanced and contextualised before being relied on for any business or investment decisions.
What does negative ROIC mean?
A negative ROIC is when a business is investing its funds in ways that do not deliver positive returns. However, as mentioned above, a low or even negative ROIC is not necessarily bad. If a business is investing its funds wisely, for example into assets that will deliver long-term results or into purchasing complementary businesses, a low or negative ROIC can indicate the early stages of a growth plan. A low or negative ROIC might also be a result of a strategic business plan to win market share in a competitive environment.
What does positive ROIC mean?
A positive ROIC indicates a business has invested intelligently by spending its funds in ways that create positive returns. A positive ROIC is also likely to be releasing further funds that can be used to invest in the business. A positive ROIC is the right strategy for a business when it is looking to increase its cash flow or show growth to its investors or shareholders. It may also be looking to increase cash flow for its longer-term strategic plans.
ROIC in a recession – what’s the best strategy for a business?
During a recession executives need to assess the best way to structure expenditure in order to manage what will likely be decreased cash flow into the business.
The most natural response is to focus on ensuring BAU (business as usual) is as efficient as possible, rather than considering expansion plans or large expenditure. Pulling back from investing is not always the best way to operate in a recession, however. Some businesses thrive in an environment where their competitors may be struggling, and they are able to scoop up market share with strategic marketing plays.
As this Forbes article points out, companies offering high-quality customer experiences generally withstand recessions better than others. It recommends investing in customer service when times are good, thus preparing the business for a downturn. It also notes business leaders should be judicious in cutting costs during a recession as that can have serious long-term risks to the business’s success.
Whatever the strategy, the onset of a recession can be a good time to assess the efficiency of the business. Software systems such as Unleashed are key drivers of efficiency, and are an excellent place to start.
9 ways to improve ROIC
A company’s ROIC is a metric many investors, advisors and external parties look to when assessing a business’s future trajectory. It is therefore important for a business owner to consider how to improve their ROIC – or, if ROIC is expected to be low for some time, be able to show a solid plan for its improvement over time.
Before figuring how to improve ROIC, it is important to create a ‘benchmark’ that will help define success. That will require analysis of current returns and a clear way of assessing investment capital. Creating this benchmark will ensure analysis of improvements will be comparing ‘apples with apples’ in the future.
Once the benchmark is set, a business can explore several ways to improve its ROIC. Below, we outline nine ways in which this important metric can be improved.
1. Invest in a good software system like Unleashed
For product businesses, Unleashed offers a number of benefits for inventory management, tracking and auditing, sales and customer relationships which lead to operational efficiencies. Ineffective inventory management in particular is a significant drag on a company’s finances. Unleashed enables real-time stock visibility, meaning the business has a clear understanding of available products, the need to reorder, sales tracking, and margins.
2. Generate more profit
Finding ways to generate more profit will flow through to a higher ROIC. There are multiple ways to do this and it will require analysis of the business’s strengths or weaknesses. There may be opportunities to increase prices, particularly if they have been held for a long period of time. If this strategy is followed, it will be important to convey the information clearly to mitigate the risk of customer loss.
Another option is to consider marketing spend and if it is being used effectively, or if there is an opportunity to improve reach and conversion rates. Social media algorithms change frequently and it may be possible to improve reach and conversion without dipping into the marketing budget.
3. Reduce investment outlay
Improving ROIC may mean pulling back on expansionary plans and large cost outlays. Or at the least, it will mean auditing plans to ensure they will deliver acceptable ROIC, within a reasonable timeframe.
4. Consider your debt structure
Assess how loans are structured, including interest and fees. Can some debt be consolidated to create a lower servicing cost? Can high-interest debt be paid off faster? Debt servicing is too often set up and forgotten, and there are often benefits from time spent on making the structure more cost-effective.
5. Ensure working capital is used well
Working capital, or the cost of running the business, is often inefficient due to rapid or unstructured business expansions. As this article explains, operational changes can often be made to areas such as inventory, payroll, and operations, which in turn decrease working capital expenditure.
6. Consider the labour force, including attrition and effectiveness
Payroll is one of the biggest costs of any business, as is replacing valuable staff. Ensure staff are working to their strengths, with a regular programme of upskilling and support. Consider if some roles can be consolidated or operated in a more effective way. Conversely, consider if investing in software or hardware will allow for expansion without growing headcount.
7. Reduce fixed overheads
Post pandemic, the need for certain overheads has lessened. Many businesses are operating with a hybrid working model and outlays such as office leases may be superfluous to business needs. It is worth considering the total cost of fixed overheads and seeing if cutbacks can be made.
Equipment is also another area in which costs may be saved. For example, it will be worth asking if equipment should be better maintained to prolong its life, or if a plant can be used to run more shifts than currently on the schedule. Another worthwhile question is if more product lines can be run through the same process, without dragging on productivity.
Improvements to planning and scheduling can allow manufacturers, for example, to squeeze additional production runs into the same timeframes.
8. Build strong customer relationships, retention and conversion
Customer relationships are key to growing a business and should be front of mind when considering how to improve efficiencies. For example, it will be worth considering the communications to customers, along with opportunities to upsell, cross-sell or create long-term partnerships. Analysis of the customer base may also reveal partnerships that are no longer needed or valuable, and can be retired. This will free up time to focus on more productive partnerships.
9. Shift to a lean operating structure
The lean operating philosophy was spearheaded by Toyota in the 1950s, and brings efficiencies to all steps of the manufacturing process. It requires a systematic approach to processes that ensures each step is completed efficiently before moving to the next. It also requires constant analysis and improvement of processes that may not be working as well as they should. In recent years lean has been adopted across many different business sectors, and is credited with minimising waste without any loss in productivity.