Credit & Capital

Metric of the Month: Return on Invested Capital

Strategic CFOs know that smart investors look for organizations that effectively invest capital where it generates the best returns.
Perry D. Wiggins, CPAOctober 1, 2019
Metric of the Month: Return on Invested Capital

October falls in the middle of a busy planning season for many organizations, which is the perfect time for this month’s metric on return on invested capital (ROIC). This measure calculates the amount of gain made on invested capital relative to the cost of investment, which gives an organization the ability to track how well it uses its money to generate returns. ROIC can be calculated by dividing an organization’s net operating profit after tax by the amount of invested capital dollars and should be expressed as a percentage.

Data from APQC’s Open Standards Benchmarking database shows that organizations in the top quartile (75th percentile and above) generate almost twice the percentage return on investment as organizations in the bottom quartile (see chart below).

In addition to this cross-industry view, it’s important to benchmark your organizations against others in the same industry, since ROIC can vary widely from one industry to another. Grocery stores, for example, have razor-thin profit margins and may not see much return from invested capital, while the software industry can realize much larger gains from investments. Regardless of industry or the size of company, a higher percentage is always better when it comes to this metric.

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Across the Portfolio

Each annual planning cycle, organizations should be looking for ways to improve the returns being generated from investments. Doing so means finding the investments that will boost revenues, improve margins, lower costs, and increase velocity throughout the earning cycle. The evaluation of capital projects and detailed tracking of their returns from implementation to results are the keys to improving ROIC and the overall value of the firm.

The challenge is that ROIC is a product of the organization’s entire portfolio of investments, including those that take longer to produce returns or that produce no returns at all. In the same way that roof or plumbing repairs don’t necessarily raise a home’s value, investments to remain compliant with applicable laws or upgrades to outdated systems might not necessarily lead to higher revenues. However, those investments are still necessary. Failing to make them could cause problems that ultimately lower the value of the business.

Finance chiefs also need to remain cognizant of the fact that some returns are cumulative and take time to build momentum. Your return on an investment of $20 million might only be $70,000 in year zero but could start to yield much higher returns five to 10 years out. As they look across the investment portfolio, CFOs and finance leaders must think strategically to offset these investments with those that bring higher returns elsewhere so that the organization’s investment returns are adequate. Each firm must generate an ROIC greater than the cost of capital. Otherwise, the business is simply operating at an economic loss. Investors abandon those firms over time, and as they do, the firms’ cost of capital gets increasingly expensive — sometimes to a point that spells the end of the business.

Must Be True

Every organization needs a process to evaluate and balance investment costs with revenue. One important thing that any organization can do is test the assumptions behind a project before investing in it. Jeff Hunter, a strategy and marketing expert in the healthcare industry, advises organizations to always ask: “What must be true in order for the proposed project to be a good investment?”

As an example of what this looks like in practice, Hunter tells the story of a CEO of a health care provider who felt like his hospital wasn’t getting enough business from the surrounding towns. The CEO suspected that it was because people lacked transportation to the hospital. He was considering buying a van and hiring a driver for patients to increase business.

Rather than doing so immediately, the organization asked: “What must be true for this proposed investment to have adequate returns?” The CEO contracted a local transportation company to provide regular rides in order to validate the key assumption. It turned out that doing so didn’t bring the returns that the CEO initially imagined, and the organization was able to avoid a poor return on investment from having purchased the vans.

ROIC gives a quick and ready picture of how an organization is performing relative to its investments once they’re made. But making sure investments truly pay off takes strategic thinking and careful planning. Validating assumptions before you proceed with an investment helps ensure that you maximize your wins, minimize your mistakes, and get the returns you expect.

Perry D. Wiggins, CPA, is CFO, secretary, and treasurer for APQC, a nonprofit benchmarking and best practices research organization based in Houston, Texas.