What is return on invested capital?

Definition

Return on invested capital is operating income divided by the debt and equity funding the business. On the books, this is a rate of operating profit against the capital that paid for the assets, not a ledger account you debit.

People often shorten the name to ROIC after the full name. The percent asks what the funded capital produced from core work, before interest and taxes.

It is not a Balance Sheet line. The books already hold operating profit, loans, and equity; this reading restates them as a percent.

Stay with operating profit against debt plus equity when you read it. Leftover against equity only is a different page.

Where it shows up

P&L: Related to operating income.

Balance Sheet: Related to the debt and equity funding the assets.

Cash flow: Related to whether that return is cash.

See also: Operating Income · Return On Assets · Return On Equity

When you look at your Income Statement, take operating income, the leftover from core work before interest and taxes. Then divide by the debt plus equity that funds the assets on the Balance Sheet.

When the percent is high, the funded capital produced more operating profit. When it is low, a large pile of loans and owner capital produced little from the trucks and shop.

The Balance Sheet holds the denominator. Notes payable and other formal loans sit with equity in that total; a long-term truck note counts even if it is not due this year.

On the Statement of Cash Flows, operating profit and cash from operations can diverge. This page stays on the earnings rate, which can look healthy while school-district invoices sit uncollected.

Capital expenditures raise the assets and often the debt or equity that funded them. The rate often dips in the first months after a van or lift buy.

How it works

Start with operating income for the period. That leftover already subtracted day-to-day shop costs, but not interest and taxes.

Add the debt and equity that fund the business. Divide operating income by that total.

$60,000 of operating income against $100,000 of debt plus $200,000 of equity is 20 percent. Write it as a percent so the rate is easy to compare across years.

Stay with operating profit in the numerator. Swapping in net income folds interest into the leftover and turns this toward an equity-only reading.

Do not treat a high percent as proof the cash is in the till. Operating income can sit in unpaid service invoices while last year's van is already paid for.

A new van bought with a loan raises debt immediately and raises operating profit only as the extra calls fill. The rate often dips until the truck is busy.

Free cash flow asks what cash remained after the capital spend. This page asks what operating profit the funded capital produced, which is a different question.

This page stays on operating profit against debt plus equity. Leftover against equity only, and leftover against total assets, belong on other pages.

Example

Harbor Heat HVAC runs a regional service shop. Operating income for the year is $60,000, with $100,000 of debt and $200,000 of equity.

Add the funding: $100,000 plus $200,000 is $300,000. Divide $60,000 by $300,000, and ROIC is 20 percent.

That 20 percent is operating profit against the capital that funded the shop. It is not leftover after interest against equity only.

If the shop borrows another $50,000 for a lift and operating income stays $60,000, the denominator rises and the rate falls. The funded capital got larger before it got more profitable.

If operating income rises to $75,000 on the same $300,000 of capital, the rate is 25 percent. The funding did not change; the operating leftover did.

If half of that leftover is still sitting in unpaid school-district invoices, the Income Statement rate can still be 20 percent. The cash reading would be lower until those invoices clear.

The shop does not post a line that says this rate. The books already hold operating income, debt, and equity; you divide.

Common mix-ups

This rate is not the same as return on equity. Return on equity divides leftover after interest by equity only, so a shop funded with debt can read higher there than here.

This rate is not the same as return on assets. Return on assets divides leftover profit by total assets, including items not funded by this debt-and-equity total.

This rate is not the same as cash in the till. A 20 percent reading can sit in unpaid invoices while last year's van is already paid for.

Related terms

• Operating Income: Profit from core operations before interest and taxes.
• Equity: The owners' residual claim on the business after liabilities are subtracted from assets.
• Notes Payable: Formal loan balances owed to a bank or other lender.
• Return On Assets: Net income measured against total assets.
• Return On Equity: Net income measured against owner equity.
• Capital Expenditures: Spending to buy or improve long-lived assets.
• Free Cash Flow: Operating cash flow left after the capital spending needed to keep running.
• Balance Sheet: A statement showing what a business owns, what it owes, and what is left for owners at a single point in time.