Invested capital. Return on invested capital

When analyzing the financial indicators of an investment project, determining the profitability of the investment is considered an extremely important step. The entire investment plan is built on the basis of this indicator, and finding a parameter that can reveal the efficiency of resource sales is the most important stage of the entire process. For these purposes, the return on investment capital ratio is used.

In this article we will look at the concept of return on invested capital and learn how this economic indicator is correctly calculated.

What is considered investment capital

In a simplified sense, investment capital means the amount of money invested in a project (production or provision of services) in order to make a profit. By the nature of origin, investment capital can be divided into equity and borrowed capital.

Own investment capital is usually understood as the volume of net profit aimed at implementing investment projects. Borrowed capital includes financial liabilities, the attraction of which is associated with the alienation of part of the profit at the end of the term.

In the first case, everything is more or less clear. Funds received from activities are partially or fully allocated to expand or modernize production in order to obtain greater profits. In the case of borrowed capital, there is both a bank or other loan and the attraction of a new owner with the subsequent purchase of his share.

In this regard, one more type of investment capital should be considered - attracted, which differs in that its implementation is associated with a change in the structure of the company's owners. In other words, capital raised is considered as such when the entry of a new owner takes place in parallel with an increase in investment. This process is associated with a decrease in the share of the original owner due to the alienation of part of the shares in favor of a new participant in exchange for his cash injections.

In its structure, investment capital consists of:

• tangible assets (land plots, real estate, direct investments, etc.);
• financial assets (shares in another company, shares and debt bonds);
• intangible assets (increasing market share, conducting marketing analysis or other)

It is important to note that investment capital is considered such if it is invested only in the main activity. The same condition applies to profit. However, some experts use general data to simplify calculations. In this case, a discrepancy may be observed, the size of which is directly related to the volume of investment in various areas of activity.

Thus, we see that investment capital can have many forms and ways of implementation, but its goal remains the same - obtaining additional profit. In view of this, economists introduced an indicator. Which allows you to determine how efficiently assets are used.

What is return on investment capital

Profitability in economics is considered to be a relative indicator of efficiency. It is a kind of efficiency factor in the context of production or service provision. In other words, high-quality sales of labor, money and other resources should lead to increased profitability.

In the field of investment, profitability indicator occupies a central place. Attracting your own or borrowed assets is directly related to the desire to receive a return in the form of increasing your market share, increasing financial stability or developing a free niche.

The return on investment capital indicator is usually designated ROIC (Return of Invested Capital). It is part of a larger category called "Profitability Indicators", which combines the efficiency of use:

• shareholders' equity (ROCE);
• total assets (ROTA);
• gross (GPM) and operating (OPM) profit

The basic formula for finding the return on investment capital indicator:

NOPLAT/Investment capital

NOPLAT is a reflection of net operating income minus applicable taxes and dividends.

Practice shows that most specialists use a simplified approach to calculating ROIC, which considers the entire activity of the enterprise without dividing into core and other activities.

In this case, the appearance of an error in the calculations is inevitable, and its size is determined by the share of investments in non-core activities. Thus, the formula for finding the return on investment capital takes the following form:

ROIC=EBIT(1 – Tax rate)/Investment capital

EBIT (Earnings before interest and taxes) means profit before taxes and dividends.

All parameters are taken according to the average annual value, that is, the indicators at the beginning and end of the year are added up and divided in half. ROIC is often called the Return on Total Capital, meaning that from the moment of investment, assets become part of the total capital.

It is worth noting that the result of the calculations should be a percentage indicator that is compared with the planned one. Based on this operation, the feasibility of further investments is formed.

Purpose of the profitability indicator

As mentioned earlier, return on investment capital is one of the most important indicators of the economic efficiency of an enterprise. It shows the return on investments made, and on its basis the need for further injections is formed.

It should be noted that calculating the ROI before investing allows you to determine the feasibility of the initial investment. To more fully understand the current state of affairs at an enterprise, economists often use this indicator to find an answer to the question: is investment required at all? In other words, comparing the ROI indicator with the planned one allows you to determine whether it is worth increasing the amount of investment at all, albeit at the expense of your own funds.

Separately, it is worth mentioning such a parameter as the payback period. This indicator is closely related to profitability itself and has a direct impact on it. Each investment project has a return period - the amount of time required to receive the planned income. This indicator depends on a number of variable factors, including both macroeconomic indicators and specific features of the selected industry.

And the impact of return on investment capital must be considered inextricably from the payback period. A qualitative analysis of ROIC requires the construction of an investment plan taking into account many related indicators, for example, finding a break-even point or behavior in the event of financial force majeure.

Advantages and disadvantages

Among the obvious advantages of using the return on investment capital parameter, it is worth noting the simplicity of its calculation. As can be seen from the formulas, to obtain a result, knowledge about the amount of profit and the amount of investment are required.

Thanks to this simple formula, it is possible to determine the level of efficiency in the use of tangible and intangible assets. But this is also where its main drawback lies. Application of the formula in its initial form leads to an increase in the level of error, which, when running a large business, leads to the receipt of incorrect data, which in turn are variables in other calculations.

In other words, to determine the most accurate indicator of return on investment capital, a more detailed formula is required that would take into account a wider range of financial actions.

However, for a small business segment or within the framework of an insignificant project, such a simplified determination of the efficiency parameter should definitely be considered an advantage.

Despite the information content of the result obtained, the profitability indicator has a number of significant drawbacks that make it difficult to use.

• Impossibility of establishing the nature of the origin of income. The usual calculation formula does not allow us to determine how much income was received from operating activities, how much is part of permanent profit, and how much can be considered one-time;
• Possible manipulation of results by management. This minus directly follows from the previous one. Due to the wide variability of data and ambiguity in formulation, the use of ROI may allow stakeholders to substitute data;
• High level of dependence on external economic factors, such as inflation and the US dollar exchange rate. This point cannot be considered a drawback of only this parameter, since changes in the economic indicators of the state are the reason for changing the methods for determining efficiency, but the connection between these factors should not be denied.

Conclusion

The return on investment capital indicator is very common, as it gives a completely understandable picture of the efficiency of using an enterprise's resources. However, its use is associated with a large number of errors that do not allow its use everywhere.

One way or another, the ROI indicator is changing, taking on other forms and taking into account more and more indicators. One way or another, the return on investment capital indicator is one of the most basic ways to assess the effectiveness of financial investments.

Problems in calculating invested capital lie in the interpretation of the concept invested debt capital. In international practice, invested borrowed capital means long-term capital, but Russian companies often finance investment activities using short-term borrowed funds. That is, in practice, invested capital means both long-term and short-term debt capital, so short-term debt can and should be considered as an element of invested capital for companies operating in an unstable environment.

Another problem in calculating invested capital ratios is that there are a number of liabilities adjacent to equity, such as deferred tax liabilities, long-term provisions, intercompany loans and loans provided by the founders. These obligations are characterized by the fact that they are often free and do not always represent specific amounts payable at a specific time. The classification of these obligations as equity or borrowed capital should be determined by their economic essence, including the characteristics of the terms and conditions for fulfilling the obligations.

Taking this into account, we can give the following definition invested capital- this is the capital of the owners, as well as long-term and short-term borrowed capital of creditors invested in the company.

At the same time, short-term borrowed capital consists of borrowed funds and does not include accounts payable, deferred income, short-term estimated liabilities and other short-term liabilities. Long-term debt capital includes quasi-equity capital, long-term borrowed funds, and other long-term liabilities.

Note that, invested capital can be determined from the balance sheet asset as the sum of non-current assets and working capital. This calculation makes it possible to determine the company's net assets (the indicator is not equivalent to the net asset value indicator, calculated in accordance with the Order of the Ministry of Finance of Russia, the Federal Securities Commission of Russia dated January 29, 2003 No. 10n/03-6/pz and reflected in the statement of changes in capital).

A significant share in the structure of working capital of such components as own working capital and long-term borrowed capital ensures the financial stability of the organization and at the same time increases the cost of financing current assets.

Invested capital(IC) is calculated using the formula:

IC = E + E i + LD + LD 0 + SD

Where, E i is quasi-equity capital; E - equity; LD - long-term borrowed funds; LD 0 - other long-term liabilities; SD - short-term borrowed funds.

Borrowed capital:

D = E i + LD + LD 0 + SD

Working capital:

Where CA - current assets; AP - accounts payable, as well as deferred income, short-term estimated liabilities and other short-term liabilities.

Net working capital:

Where, CL are short-term liabilities, including borrowed funds, accounts payable and equivalent liabilities.

Own working capital:

Where, FA are non-current assets.

In the methodology under consideration, the following assumptions are made when calculating capital indicators. Liabilities adjacent to equity capital are not considered as elements of equity capital, but are recognized as quasi-equity capital and included in debt capital, since this is consistent with the principle of conservatism, which ensures a more adequate, not inflated assessment of the company’s equity capital and financial stability. The quasi-equity capital includes deferred tax liabilities and estimated liabilities. Intra-group loans and loans of founders are considered as borrowed funds, since according to the financial statements it is almost impossible to separate these obligations from the total amount of liabilities. Thus, a company's borrowed capital is considered as the sum of its components: quasi-equity capital, long-term borrowed funds, short-term borrowed funds and other long-term liabilities. That is, short-term borrowed funds are included in borrowed capital, since this reflects the prevailing practice in Russian companies for calculating the indicator.

To perform an analysis based on Russian reporting data, it is necessary to additionally calculate a number of profit indicators that are not published in the reporting, but are necessary to evaluate the company’s activities. This is earnings before interest, taxes, depreciation, and amortization (EBITDA), which is used to both evaluate a company's profitability (EBITDA margin) and debt burden (net debt ratio). Further, this is an indicator of earnings before interest and tax EBIT, which is used to calculate return on net assets (ROA), the value of which decisively affects the indicators of financial leverage (differential, effect of financial leverage). It is also the net operating profit NOPAT, which is used to calculate return on invested capital ROIC, based on a comparison of which with the weighted average cost of capital WACC, the conclusion about the value created or destroyed by the company is justified. Finally, there is the economic profit EP, which is also an indicator of the value created by the company.

When calculating profit indicators not published in Russian financial statements, the following assumptions were made:

1. other financial result is calculated as the difference between other income and other expenses, not including interest payable, and is considered as a component of operating profit;
2. Current income taxes, as well as changes in deferred tax assets and liabilities, are taken into account when calculating net operating income, financial leverage ratios and other indicators by determining the effective income tax rate.

The algorithm for calculating profit indicators is as follows:

Earnings before depreciation, interest and taxes:

EBITDA = PS + A + FR

where PS is profit from sales; A - depreciation; FR - other financial result, which does not include interest payable (calculated as the amount of other income reduced by the amount of other expenses).

Earnings before interest and tax (operating profit):

Net operating profit:

NOPAT = EBIT * (1 - tе)

where te is the effective income tax rate as the ratio of current income tax and deferred taxes to profit before tax.

This indicator is calculated using the formula:

te = (Nf + Nd)/EBT = (EBT - NP)/EBT

where Nf is the current income tax; Nd is the amount of changes in deferred tax assets and deferred tax liabilities; EBT - profit before tax; NP - net profit.

Economic profit:

EP = NP - Ke * E

where Ke is the cost of equity as a source of capital; E - equity.

Basic profit is calculated as net profit reduced by the amount of dividends on preferred shares accrued for the reporting year. Basic earnings (loss) per share is determined as the ratio of basic earnings for the reporting period to the weighted average number of ordinary shares outstanding during the reporting period. To estimate the basic earnings per share, it is necessary to correlate this indicator with the market value of the share. The resulting ratio will characterize the potential return on investment in a share, which should not be lower than an alternative return with a comparable level of risk.

Diluted earnings measure the possible reduction in basic earnings per share that could occur as a result of issuing shares in the future without a corresponding increase in assets. Profit dilution occurs in the following cases:

• conversion under certain conditions of all convertible securities of a joint-stock company into ordinary shares;
• upon execution of all contracts for the purchase and sale of ordinary shares from the issuer at a price below their market value.

The lower the diluted earnings relative to the underlying earnings, the riskier the equity investment, as underlying earnings per share are likely to decline in the future. The diluted profit indicator may be equal to the basic profit indicator, which means that the company’s capital structure is simple, i.e. it does not have any convertible securities or options or warrants that would allow the shares to be sold at a price below their market value.

An example of calculating indicators of invested capital

The values ​​of the presented indicators are calculated further on the basis of new reporting forms for a Russian manufacturing company. The initial data for the calculations are presented in the attached tables.

Assessing the information provided in the reporting forms valid since 2011, it can be noted that some of the newly introduced indicators in the reporting have a zero value for the company under study. In particular, the lack of research and development results indicates its low innovative activity. The absence of values ​​in equity for the item “Revaluation of non-current assets” and a similar item in the income statement indicates that the company does not carry out revaluations, but this does not exclude the possibility that the book value of its non-current assets differs from their market value . The absence of values ​​for the article “Estimated Liabilities” indicates the insignificance of such liabilities for the analyzed company.

The results of calculating the company's capital indicators are presented in Table 1.

Table 1. Calculation of capital indicators

The results of calculations based on the data presented provide grounds for a number of conclusions. The structure of the net assets of the analyzed company is light, since working capital predominates in it; non-current assets have a lower share, which leads to a low level of operating leverage and allows the company to increase financial leverage by attracting borrowed capital. The company's capital structure can be characterized as aggressive, since the share of equity capital in invested capital does not exceed 40%.

At the same time, the company's debt capital is dominated by long-term borrowed funds, which increases its financial stability. The company does not have its own working capital due to the fact that non-current assets exceed the amount of equity capital and are partially financed by long-term borrowed capital. This increases the company's riskiness, but reduces its weighted average cost of capital. The company's invested capital decreased by 5.6% during the analyzed period, which indicates a slight slowdown in business and is associated with a decrease in the company's working capital. The results of calculating the company's profit indicators are presented in Table 2.

Table 2. Company profit indicators

Analysis of the profit and loss statement also provides grounds for negative conclusions about the financial performance of the company. As follows from the analysis of the data presented in Table 2, all financial performance indicators are declining. At the same time, the rate of decline in indicators increases from a 3% decrease in revenue to a 90.4% decrease in net profit, which indicates not only the stagnation of the company’s activities and a reduction in production and sales of products, but also ineffective cost control, leading to an accelerated decrease in profit indicators relative to decrease in revenue. As a result of these trends, the revenue structure worsened, so the share of net profit decreased from 6 to 0.6%. However, the most significant conclusion concerns economic profit, which is calculated under the assumption that the cost of equity capital is equal to 20% per annum. The company has gone from being a value creator to being a value destroyer.

When completing the analysis of the company, it is necessary to assess the primary factors of business value, the values ​​of which are presented in Table 3.

Table 3. Primary cost factors, %

As follows from the calculations, the company destroys value in the reporting year, since return on invested capital (the ratio of net operating profit to invested capital) is lower than the market weighted average cost of capital. The cost of equity capital is 20%, the cost of debt capital is 13%. At the same time, performance indicators sharply deteriorated in the reporting year.

Bibliography:

1. Bernstein L.A. Analysis of financial statements: theory, practice and interpretation / Transl. from English M.: Finance and Statistics, 2002.
2. Koltsova I. Five indicators for an objective assessment of your company’s debt load // Financial Director. 2011. No. 6.
3. Kogdenko V.G., Krasheninnikova M.S. Features of the analysis of new forms of accounting statements (balance sheet and profit and loss statement) // Economic analysis: theory and practice. 2012. No. 16.
4. Salostei S. How much is the company’s equity capital // Financial Director. 2011. No. 7.

The basic decision-making model for investing capital in a new or existing project is based on how much benefit the entrepreneur will receive and when. In educational and academic literature one can find many different methods for calculating the efficiency of investment capital, but most of them are hardly suitable for use in practice due to their complexity, operating with extensive statistical data, etc.

This article will discuss the main methods for assessing the return on invested capital, which are quite widely used in practice and working with which does not cause difficulties even for an entrepreneur who is not experienced in econometrics.

Basic models for calculating company value and return on investment in business

As you know, the value of a business (a separate company or a holding) is determined by its ability to produce a positive cash flow (financial result) in a specific period of time. This ability is largely determined by the extent to which the existing business model has the ability to reproduce the capital invested in it and generate additional profit.

There are several basic models used to assess the effectiveness of a company's investments, which can be presented as follows:

1. Business discounted cash flow model
2. Economic profit model

These two main models are most widely used in practice, and they are included in the curricula of almost all universities where there are economic disciplines. For example, the discounted value method most clearly shows how much the company's generated profit is sufficient to cover all costs and expenses of investments.

In addition to these two defining models, there is also a method for calculating return on investment used for specific types of business:

1. Adjusted present value model— used to assess the return on investment of companies that have a flexible cost structure (for example, companies built on the principle of a holding company or operating as a network project).
2. Cash flow model for shares (share in authorized capital)— is intended mainly for companies with a joint-stock capital structure, working with client portfolios, banks and insurance companies.

Methodology for using basic models to evaluate ROI

The discounted cash flow model for a business enterprise uses a company's cost of equity, which is defined as the valuation of its core business minus debt obligations and other legal payments to investors (such as payments on bonds or preferred stock). The cost of operating activities (operating cost) and the cost of debt equal the corresponding cash flows discounted at rates that reflect the risks associated with the business.

This model is mainly used to evaluate companies that have one type of business as a single entity. To use it in cases where a company consists of several subsidiaries, one should resort to an assessment of each individual structure plus the costs of overall corporate governance.

The value at the end of a particular forecast period can be estimated using the extended value formula:

Where:

• NOPLAT− net operating profit less adjusted taxes (in the first year after the end of the forecast period);
• ROIC− incremental profitability of new invested capital;
• WACC− weighted average capital costs;
• g− expected growth rate of NOPLAT in the indefinite future

The key elements in this model appear to be:

1. Return on invested capital (return on invested capital ratio)
2. Weighted average cost of capital.

Return on invested capital is determined in a relatively simple way, which can be expressed by the following expression:

Where:

• NOPLAT is net operating profit adjusted for taxes and mandatory payments.
• Invested capital is operating working capital + net fixed assets + other assets necessary to implement the investment project.

Return on invested capital shows how the investor's invested assets are capable of bringing him profit, the level of which, at a minimum, should not be lower than the inflation rate (or the interest rate if the investment is made on margin terms, i.e. in debt).

In order for this coefficient to always be greater than 1 (one), it is necessary for the investor to comply with a number of conditions or adhere to a certain set of funds that have the ability to increase the return on invested capital.

Such methods could, for example, be:

1. increase the level of profit that a business receives from capital already invested (i.e., increase the return on capital invested in existing assets);
2. ensure that the profitability of any new investment exceeds the weighted average cost of capital or, in other words, the break-even point of each subsequent business should be higher than the previous one;
3. accelerate growth rates, but only as long as the return on new investments exceeds the weighted average cost of capital, i.e. using economies of scale in production until costs begin to exceed a certain optimal level of costs;
4. reduce capital costs by minimizing costs, tax optimization, using new technologies, etc.

This simple method for calculating the effectiveness of investments both in an existing business and in a completely new project cannot cover the specifics of each individual type of business activity. Therefore, there are many industry-specific or detailed methodologies for calculating ROI, such as the method used for accounting purposes on a company's balance sheet.

Methodology for calculating return on investment according to IFRS standards

Since many Russian companies have close ties with foreign counterparties, and many are simply integrated into international corporations, it makes sense to consider a model for assessing return on investment, used according to the uniform standards of developed countries. At its core, this is a factor analysis of return on invested capital, where the main elements are considered assets taken into account in the balance sheet of companies, as presented in the following diagram:

The already familiar formula for the return on investment ratio has the same form, but with a more expanded consideration of factors influencing the final performance indicators of the invested capital:

Where the main elements of NOPAT (operating profit before taxes) and IC (invested capital) are presented in a more detailed form, or the so-called “balance sheet formula”: “NOPAT”

Where:

1. EBIT – earnings before interest and taxes;
2. IL – interest payments on leasing (Implied interest expense on operating leases);
3. ILIFO – increase compared to the purchase price of inventories accounted for using the LIFO method (Increase in LIFO reserve);
4. GA – goodwill amortization;
5. BD – increase in bad debt reserve;
6. RD – increase in long-term R&D costs (Increase in net capitalized research and development);
7. TAX – the amount of taxes, including income tax (Cash operating taxes).

"IC" (invested capital)

Where:

1. BV – book value of common shares (Book value of common equity) or authorized capital;
2. PS – preferred shares (Preferred stock);
3. MI – Minority interest
4. DTAX - Deferred income tax reserve
5. RLIFO – LIFO reserves
6. AGA - Accumulated goodwill amortization - intangible assets
7. STD – short-term debt on which interest is charged (Interest-bearing short-term debt)
8. LTD – long-term debt capital
9. CLO – capitalized lease obligations
10. NCL – present value of non capitalized leases

As a conclusion to this article, we can conclude that the presented models for assessing the effectiveness of investments reflect a fairly general approach. But, nevertheless, an idea of ​​how the elements of a business model affect the final result will help many novice investors or entrepreneurs to correctly assess all the factors that determine the ultimate success of investing.

The main objective of investing is to obtain maximum income from investments. In order to predict the likely profit and evaluate the financial performance of the project, various mechanisms are used. In this article we will look at the return on invested capital and find out how and with the help of what mechanisms it can be calculated correctly.

Invested capital

The concept of invested capital is understood as the amount of funds allocated for the implementation of the project, the development of the production of goods and services in order to obtain the maximum possible profit. In this case, sources of investment can be internal or external.

Among the internal means of investment, one can highlight a part of the net profit, which is directed to the implementation of financed projects. External, or borrowed, funds include resources, the use of which is associated with the subsequent withdrawal of part of the profit to repay these investments.

The first option involves investing a share of the profit received in the development or improvement of production, as well as increasing labor efficiency. This, in turn, leads to an increase in revenue from goods and services sold. Borrowing from external sources most often takes the form of bank loans or raising funds from partners.

It should be noted that it consists of several structural units. These include tangible assets, financial assets, as well as intangible funds. The former include, for example, land and real estate. Financial assets include shares, debt and interests in other businesses. Intangible assets are activities aimed at increasing business, such as increasing market presence or conducting market research.

Return on invested capital

One of the main places in the field of investment is occupied by the return on invested capital. This parameter shows how effective is the investment of own or borrowed funds in the investment object. The task of any business is to increase the company’s share in the market, gain financial stability, as well as occupy new free niches for the production and sale of goods and services. Return on invested capital is a convenient parameter for indicating these processes.

Profitability ratio

To determine profitability, it is customary to use the ROIC (Return of Invested Capital) coefficient. It should be noted that this index belongs to the category of indicators of the efficiency of use of such funds as total assets, share capital, gross and operating profit. The formula for calculating this coefficient is as follows: income - cost / investment amount.

Why do you need a profitability ratio?

It should be emphasized that determining the rate of return on invested capital before investing money in a project makes it possible to find out how appropriate the initial investment is in a particular situation. In addition, in many enterprises, economists use the ROIC indicator of return on invested capital to understand the need for investment as such.

Inextricably linked with the return on invested capital is a factor such as payback. It is this indicator that indicates the period of time over which the invested funds will bring the expected income. Payback is influenced by several circumstances, including macroeconomic indicators, as well as the characteristic features of a particular sector of the national economy.

In conclusion, we should mention the main advantages and disadvantages of calculating profitability. The advantage is a fairly simple method for calculating the ROIC coefficient. As mentioned above, for this it is enough to know the value of the probable profit and the volume of investments. The main disadvantage of calculating profitability is the presence of errors caused by the presence of unaccounted financial actions.

However, for small businesses and not too large investment projects, the described formula for calculating the return on invested capital ratio is certainly sufficient.

Definition

Return on Capital Employed, or return on capital employed (ROCE) - an indicator of the return on the organization’s own capital involved in commercial activities and long-term funds raised (long-term loans, borrowings).

Calculation (formula)

Return on Capital Employed = / Capital Employed = EBIT / (Equity + Long-term liabilities)

where EBIT is earnings before interest and taxes

Often the indicator is calculated as a percentage, i.e. additionally by multiplying by 100. In addition, a more accurate calculation would be where the denominator indicators are taken as annual averages (i.e., the value at the beginning of the year plus the value at the end of the year divided by 2).

Normal value

The indicator has no normative significance. But its importance lies in the fact that it acts as a guideline for assessing the feasibility of an organization raising borrowed funds at a certain percentage. If the interest on the loan is higher than the return on capital employed, this means that the organization will not be able to use the loan effectively enough to earn the interest on it. Therefore, it makes sense to take only those loans whose interest rate is lower than the return on capital employed.

Return on invested capital

Return on Capital Employed (ROCE) should be distinguished from the similar indicator “Return On Invested Capital” (ROCI), in which the denominator is the total amount of capital of the organization, and the numerator is NOPAT (after-tax operating profit) or net profit minus dividends.