We are working on an acquisition. My boss wants me to calculate the Return on Invested Capital (ROIC) for the target company. She does not want me to calculate our Return on Investment ROI for the acquisition. I think she wants me to measure the effectiveness of their internal capital investments. I am not sure how to calculate return on invested capital.
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Return on invested capital (ROIC) is a measure of the profit (returns) generated by a business as a percentage of the amount that has been invested in the business (capital) - typically over the course of a year but can be measured over any period. ROIC is particularly useful when compared to a companies weighted average cost of capital (WACC). If ROIC is greater than WACC, then the business is generating profits that exceed their costs of obtaining the funds necessary to operate. If ROIC is lower than WACC, then the business is essentially paying more to obtain financing than they are able to generate in profits after investing those funds.
The basic formula for ROIC is relatively straightforward: Net Income (less dividends or distributions) / Total Capital = ROIC
In practice, calculating ROIC can get a bit complicated because it is often necessary to make adjustments to both the net income and total capital figures in order to generate a useful ROIC metric.
Typical adjustments to net income include eliminating non-operating income and expenses with related tax adjustments in order to arrive at a net operating profit after tax figure (NOPAT). Some organizations also choose to eliminate other one-time or unusual items that are included in operating income.
Total capital is calculated by adding debt and equity less cash on hand. Typical adjustments to capital include adding off-balance sheet debts and eliminating assets held for disposal (that are generating non-operating income or losses).