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

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.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success

Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
Nyka Smith
2021-02-18
Every concept is very well explained by Nilay Arun. kudos to you man!