Return on Invested Capital and Competitive Advantage

Return on invested capital (ROIC) measures the profitability of the capital invested by the company’s shareholders and debt holders.

$$\text{ROIC}=\frac{\text{Net operating profit less adjusted taxes (NOPLAT)}}{\text{Invested capital}}$$

NOPLAT is earnings before interest expense which is earnings available to equity holders and debt holders. The invested capital is calculated as operating assets less operating liabilities.

ROIC is a better measure of profitability relative to return on equity because it is not affected by a company’s degree of financial leverage. Sustainably high ROIC is a sign of competitive advantage. To increase ROIC, a company must either increase earnings, reduce invested capital, or both.

Return on capital employed (ROCE) is operating profit divided by capital employed (debt and equity capital). ROCE can be used to compare companies with different tax structures.

$$\text{ROCE}=\frac{\text{Operating profit}}{\text{Capital employed (debt and equity capital)}}$$

Question

Which of the following is the return most likely to be used to evaluate companies in different tax jurisdictions?

1. Return on capital employed.
2. Return on invested capital.
3. Net operating profit less adjusted taxes.

Solution

The correct answer is A. 

Return on capital employed is a profitability measure that is used to compare companies with different tax structures. It uses pre-tax measures to calculate return.

B is incorrect. Return on invested capital measures the profitability of capital invested by a company’s shareholders and debt holders. The numerator in the return on capital invested is tax adjusted.

C is incorrect. Net operating profit less adjusted is a financial metric that calculates a firm’s operating profits after adjusting for taxes. 

Reading 22: Industry and Company Analysis

LOS 22 (f) Describe the relationship between return on invested capital and competitive advantage.