What is the Return on Invested Capital?

The return on invested capital compares a firm’s return on capital to its cost of capital. If the comparison yields a positive number that exceeds the current inflation rate, this means that the firm is doing a good job of allocating its funds to projects that yield a reasonable return. Conversely, if the return on invested capital is negative, this means that the company is destroying it own capital. A business that can consistently generate a positive return on invested capital is well-managed and so is more likely to be a reasonable investment choice for an investor.

How to Calculate the Return on Invested Capital

To calculate the return on invested capital, subtract dividends from net income, and then divide the result by the sum of all debt and equity. The formula is:

(Net income – Dividends) ÷ Sum of all debt and equity = Return on invested capital

The calculation should be based on the operating results of a business, excluding the financial effects of all one-time or unusual events. This approach yields a truer picture of the ability of a firm to profitably invest funds in its operations.

When to Use the Return on Invested Capital

The return on invested capital is most useful in the following situations:

Evaluation of investment efficiency. The ratio can be used to analyze whether a company is deploying its capital effectively compared to peers or the cost of capital.
Intra-industry comparisons. The ratio can be used to benchmark performance against competitors.
Merger analysis. The ratio can be used to gauge the effectiveness of past acquisitions or the potential return on new deals.
Identify red flags. The ratio can be used as part of financial due diligence to spot trends that require deeper investigation. If the ratio consistently drops, it may signal poor capital allocation decisions or increased competition.