Calculation of Return on Invested Capital | The Investment Quadrant by The Fifth Person

Questions › Category: Financials Quadrant › Calculation of Return on Invested Capital

Jieren Zheng asked 5 years ago

Hi Guys,
I was reading on ROIC, but I see many methods of calculating it, I was wondering which one do you guys use?
I am thinking of EBIT divided by Equity+Long Term Debt-Cash.
Warmest regards
Jieren

3 Answers

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Victor Chng answered 5 years ago

Hi Jieren,

Sorry for the late reply as I just got back from an overseas trip. We usually use the EBIT by Total Capital as you mentioned.

Jieren Zheng replied 5 years ago

Thanks!

Haha I saw that, sounds like you enjoyed it loads!

Victor Chng replied 5 years ago

Haha Ya quite a fruitful trip. Did some scuttlebutt there too. :)

Jayden Lee replied 4 years ago

Hi Victor,

I encountered the same problem as Jieren.

1. May I know why the Fifth Person chose to use EBIT by Total Capital instead of NOPAT (Net Profit After Tax )/ Invested Capital

2. And what does the Total Capital in your formula comprise of (i.e. how do I calculate Total Capital)?

Invested Capital has so many definitons online. Here are just a few sources.

Source 1 : Credit Suisse
https://research-doc.credit-suisse.com/docView?language=ENG&format=PDF&sourceid=csplusresearchcp&document_id=806230540&serialid=dBve3cH%2BHSFm1zoXnWVgk5IQuQtvgQ0DzQcLoCRUF2Q%3D

Invested Capital = Short-term debt + Long-term debt + Deferred taxes + Other long-term liabilities
+ Preferred stock + Shareholders’ equity

Source 2: Valuewalk.com
https://www.valuewalk.com/2017/04/calculate-return-on-invested-capital/

Invested Capital = Short-term debt + Long-term debt + Shareholder equity – Cash/equivalents – Goodwill

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Victor Chng answered 4 years ago

Hi Jayden,

The total capital is the sum of the debt and equity.

You are right there are many formula to the ROIC it depend on which one you want to use. We use the EBIT because it is the operating profit of the company. The taxation can varies in percentage for the company so the purest form should be EBIT.

Jayden Lee replied 4 years ago

Hi Victor,

Thank you for your answer. Do we have to subtract the “cash”, “cash equivalents” and”goodwill” from the total capital since cash and goodwill are not utilised to operate the business.

I came across a source that states that a company uses 5% of cash to operate the business (working capital) and the rest (95%) is deemed excess cash and therefore should be subtracted from invested capital.

What is the Fifth Person’s opinion on taking excess cash out of total capital? If we really want to take excess cash out from total capital, how to determine the excess cash?

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Victor Chng answered 4 years ago

Hi Jayden,

We did not take the excess cash out.

My personal opinion is to focus more on the business and management segment, as much as I want to focus on financial numbers but still it is the business and management that create out the numbers. In my earlier investing journey, I am a number person and it caused me to miss out a lot of good companies that eventually did very well. I try to keep financial ratio as simple as possible.