A firm’s return on invested capital is a profitability ratio, which measures a business’ efficiency in reinvesting profits which it has earned through its business operations. The return on the invested capital ratio is extremely important because it illustrates how effective the firm is at allocating capital and compounding profits. Using the metric of return on invested capital is particularly useful when investing for the long term as the investor can understand how effectively a business is able to generate profits on an ongoing basis.
A business with high returns on invested capital will usually be able to grow profitability over time, while businesses that have low returns on invested capital will generally be mediocre investments over the long run. Businesses which generate large amounts of free cash flow and are able to profitability reinvest funds into the business are very high-quality businesses that create large amounts of wealth for their owners. Owners of business which have a high return on invested capital are generally willing to hold their stakes for long periods of time as their wealth increases progressively.
The formula for calculating return on invested capital is:
Net income- dividends / debt + equity.
For example, a firm which lists $100,000 as net income, pays $20,000 in dividends has debt of $300,000 and equity of $80,000 has a return on invested capital of 21%.
Generating high returns on excess capital
There are a number of factors which impact a firm’s ability to generate a high return on additional capital:
1) The percentage of earnings which can be reinvested into the business: This will be impacted by the scope of the business operations and the ability which a business has to grow. How scalable are business operations? Can the business be grown in an intelligent manner?
2) Return on investment (ROI): What are the returns that a business achieves when it reinvests into its business? Can the firm achieve returns above 15% sustainability and even increase its return.
3) Allocation of excess capital: If the business cannot intelligently reinvest into its current operations how can it continue to create value. Could it potentially acquire other business, pay higher dividends or repurchase its own stock? This is crucial for businesses that are in a stage of maturity are reinvesting less than 100% of their retained earnings.
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