ROIC for SMEs: Why profits shrink as revenue rises
Return on invested capital, or ROIC, is one of the most reliable performance metrics for spotting a well / poorly managed SME business. ROIC is always expressed as a %.
ROIC is applicable to all businesses of all sizes, whether revenue generated is $10 or $10 million.
It is the best gauge for comparing the relative profitability levels of companies of all sizes, as long as there is capital sunk into the business.
Calculating ROIC enables SME owners to learn how much true value their company is creating.
In spite of its importance, ROIC is not tracked like Profit to Earnings ratio or Return on Earnings.
My preferred benchmark for comparing performance between SME companies is ROIC.
In performance management, ROIC is the primary metric that determines whether a SME company is doing well or poorly.
Calculating ROIC
ROIC = cash rate of return on capital that a company has invested.
Simply, ROIC shows how much cash is going out vs. how much is coming in.
It measures cash-on-cash yield.
It tracks effectiveness of the company's employment of capital.
The formula looks like this:
ROIC = Net Operating Profits After Tax (NOPAT) / Invested Capital
In the complex financial statements published by companies, generating an accurate number from the formula can be difficult.
Start with invested capital.
Representing all the cash that investors have put into the company, invested capital is derived from the assets & liabilities of the balance sheet.
NOPAT is the same as net income. NOPAT only includes profitability of operating activities.
Reported net income needs to be adjusted to represent operations more accurately. NOPAT does not include net income comes from outside investments.
ROIC as a performance metric
ROIC > WACC
If ROIC is greater than the company's weighted average cost of capital (WACC), the company is creating value for investors.
WACC represents the minimum rate of return at which a company produces value for its owners.
Let's say a company produces a ROIC of 20% & has a cost of capital of 16%. That means the company has created 4 cents of value for every dollar that it invests in capital.
If ROIC < WACC, the company is eroding value, & owners will observe the phenomenon that as revenue increases, profit declines.
The extent to which ROIC exceeds WACC provides an extremely powerful tool for choosing business projects.
The Profit to Earning ratio, on the other hand, does not tell investors whether the company is producing value or how much capital the company consumes to produce its earnings.
SME owners must also review the trend.
Falling ROIC can provide an early warning sign of a company's difficulty in choosing business projects.
Rising ROIC indicates that managers are more effectively allocating capital investments by choosing the right projects.
Calculating WACC
Cost of capital depends on the mode of financing used, it refers to:
1) the cost of equity if the business is financed solely through equity, or
2) the cost of debt if it is financed solely through debt.
Many companies use a combination of debt and equity to finance their businesses, the overall cost of capital is derived from a weighted average of all capital sources.
The cost of capital represents a hurdle rate that a company must overcome before it can generate value. It is extensively used in the capital budgeting process to determine whether the company should proceed with a business project.
The cost of debt is merely the interest rate paid by the company on such debt.
The cost of equity is more complicated, since the rate of return demanded by investors/partners/owners is not as clearly defined as it is by lenders.
The firm’s overall cost of capital is based on the weighted average of these costs.
Consider an SME company with a capital structure consisting of 60% equity and 40% debt; its cost of equity is 12% and after-tax cost of debt is 25%.
Therefore, its WACC would be (0.6 x 12%) + (0.4 x 25%) = 17.2%.
ROIC is applicable to all businesses of all sizes, whether revenue generated is $10 or $10 million.
It is the best gauge for comparing the relative profitability levels of companies of all sizes, as long as there is capital sunk into the business.
Calculating ROIC enables SME owners to learn how much true value their company is creating.
In spite of its importance, ROIC is not tracked like Profit to Earnings ratio or Return on Earnings.
My preferred benchmark for comparing performance between SME companies is ROIC.
In performance management, ROIC is the primary metric that determines whether a SME company is doing well or poorly.
Calculating ROIC
ROIC = cash rate of return on capital that a company has invested.
Simply, ROIC shows how much cash is going out vs. how much is coming in.
It measures cash-on-cash yield.
It tracks effectiveness of the company's employment of capital.
The formula looks like this:
ROIC = Net Operating Profits After Tax (NOPAT) / Invested Capital
In the complex financial statements published by companies, generating an accurate number from the formula can be difficult.
Start with invested capital.
Representing all the cash that investors have put into the company, invested capital is derived from the assets & liabilities of the balance sheet.
NOPAT is the same as net income. NOPAT only includes profitability of operating activities.
Reported net income needs to be adjusted to represent operations more accurately. NOPAT does not include net income comes from outside investments.
ROIC as a performance metric
ROIC > WACC
If ROIC is greater than the company's weighted average cost of capital (WACC), the company is creating value for investors.
WACC represents the minimum rate of return at which a company produces value for its owners.
Let's say a company produces a ROIC of 20% & has a cost of capital of 16%. That means the company has created 4 cents of value for every dollar that it invests in capital.
If ROIC < WACC, the company is eroding value, & owners will observe the phenomenon that as revenue increases, profit declines.
The extent to which ROIC exceeds WACC provides an extremely powerful tool for choosing business projects.
The Profit to Earning ratio, on the other hand, does not tell investors whether the company is producing value or how much capital the company consumes to produce its earnings.
SME owners must also review the trend.
Falling ROIC can provide an early warning sign of a company's difficulty in choosing business projects.
Rising ROIC indicates that managers are more effectively allocating capital investments by choosing the right projects.
Calculating WACC
Cost of capital depends on the mode of financing used, it refers to:
1) the cost of equity if the business is financed solely through equity, or
2) the cost of debt if it is financed solely through debt.
Many companies use a combination of debt and equity to finance their businesses, the overall cost of capital is derived from a weighted average of all capital sources.
The cost of capital represents a hurdle rate that a company must overcome before it can generate value. It is extensively used in the capital budgeting process to determine whether the company should proceed with a business project.
The cost of debt is merely the interest rate paid by the company on such debt.
The cost of equity is more complicated, since the rate of return demanded by investors/partners/owners is not as clearly defined as it is by lenders.
The firm’s overall cost of capital is based on the weighted average of these costs.
Consider an SME company with a capital structure consisting of 60% equity and 40% debt; its cost of equity is 12% and after-tax cost of debt is 25%.
Therefore, its WACC would be (0.6 x 12%) + (0.4 x 25%) = 17.2%.