How to Calculate ROIC and Why It Matters for Business Success

Profit and cash flow matter—but they don’t tell the whole story. In this video, Steve breaks down how to calculate ROIC (Return on Invested Capital) and why it’s one of the most important metrics for measuring true business performance.

You’ll learn how two companies with the same revenue can produce very different returns—and how ROIC helps you see which one is actually using capital wisely. If you want to build a more efficient, profitable business, this is a number you can’t afford to ignore.

TRANSCRIPT:

If you're running a business and you're monitoring profit and cashflow, congratulations, you're off to a great start. However, there is one ratio that if you're not paying attention to it, you could be missing out on the true economic picture of your business. That's what I'm gonna explain to you now. It's called return on invested capital.

My name is Steve Coughran. I'm the founder of Coltivar. I've spent my entire career turning around and growing businesses. And on this channel, I help business leaders like you understand what cashflow is so you can go get more of it and make your company more valuable. Let's go ahead and jump into this concept of return on invested capital.

So as a CFO, I've worked with a lot of businesses. I've ran a lot of businesses. I've grown a lot of companies. And this concept has been crucial to understanding if my business is actually creating value and if our strategy is actually working. So I'll break down those concepts here in this video now.

Let's start with this. Let's just say we have two companies, company A and company B. And here with company A, let's just imagine they are making $100,000 in revenue and company B is making $100,000 in revenue. So they're doing the same amount in sales, but their profit, and we'll say their net operating profit after tax, this is just their profit after tax from operations. Let's just say with company A, they're making $50,000, not too bad, because that is, it's NOPAT margin. This is a 50% margin on their revenue. I just took $50,000 divided by $100,000 of revenue and that gave me 50% there. So pretty healthy, right?

Now, company B, let's just imagine they're making $30,000 in NOPAT at a 30% profit margin. All right, which company would you rather own? Now, for most people, okay, they immediately go to company A and they're like, yeah, Steve, I'm not a dummy. I'm gonna choose company A because they're making more money. And you should always own a business with high profit margins, right? That's what we're taught. However, there's one piece of information that is missing that may change your mind. Let me show you.

There's this concept called invested capital. All right, I'm gonna keep things simple and not get nerdy with you, but they're really just two components. So it's not that scary. You have working capital and you have net P, P and E, property, plant and equipment.

Let me explain. When you go to the balance sheet, if you look under current assets, so you just take your current assets and you exclude excess cash. So if your company is sitting on a ton of cash, more cash than you need to run normal operations, you wanna exclude that excess cash. And then you subtract out current liabilities and you want to exclude, so exclude, I'll abbreviate there, interest bearing liabilities, okay? So if you have a line of credit, for example, and you're paying interest on that, you're gonna wanna exclude that from the calculation from your current liabilities because we don't wanna have any interest bearing liabilities in the formula, right?

So when we do that, right, and we do the math here, this gives us our working capital, right? Now, net P, P and E is found on the balance sheet as well. And essentially, this is just the sum of all your equipment. This is a truck, if you didn't know what that is. You may own a tractor. This is a tractor here. You may own a building, right? So you wanna take all your property, plant and equipment, all this stuff right here, net depreciation, right? So you wanna exclude depreciation, the accumulated depreciation on these items. And that will give you a number here for your net P, P and E.

So if you take your working capital plus your net P, P and E, you add it together, bam, you arrive at invested capital. This is the amount of money that's tied up in your business, which enables you to earn revenue and ultimately to generate profit, right? So it's trapped in your business. It's your money trapped in the business.

So check this out. Let's just say company A has $1 million in invested capital and company B has $50,000 in invested capital. Did I just change your mind? Would you rather own company B now or are you still sticking with A?

All right, let's do the math here and let me show you how return on invested capital works. So the formula is pretty simple. It's just NOPAT, net operating profit after tax divided by invested capital, right? So if we come up here and we do the math and we take $50,000 in NOPAT divided by 1 million, we get 5%. Now, if I take $30,000 in NOPAT divided by $50,000 in invested capital, I get 60%, 0.6, right?

So now think about this. Company B, you only have to put $50,000 into the company and it generates $30,000 in profit. Company A, you have to put a million dollars. That's a ton of money to put into the business to only generate a 5% return.

Now, think about this. As it compares to the S&P 500, the stock market, right? If you look at the average return over the last 50 years, it's around 10%. Now, I'm being a little dramatic here and I'm not saying go sell your business, but if you're company A, it's like, dang, you have to deal with so many issues, with customers, with employees, with just all the headaches of running a business and you're only squeaking out a 5% return. You're almost better off just like shutting down the business and putting your money in the S&P 500 and earning a 10% return.

Now, obviously, like I said, I'm being dramatic. I don't think you should shut down your business. I think there are ways to improve your business through strategy. I'm a big strategy and finance guy. I combine them together, those principles, in order to drive higher returns. That's what I do for my clients at Coltivar.

All right, now over here, company B, they're earning a 60% return, which is great. It's amazing. And they're doing it off just a little bit of capital. Now, this is a concept that a lot of business owners, they don't understand. When you start to understand it and you incorporate the balance sheet into your financial analysis and your financial reviews every month, which hopefully you're doing, it changes the picture entirely, okay?

So we're not done. I wanna show you how this all ties into strategy. But one caveat, return on invested capital doesn't always work. There's some businesses that are asset light, like tech companies, professional service businesses, where return on invested capital doesn't always work out. Or if you have heavy investments in the beginning of your company, return on invested capital may get a little wacky. That's where you wanna compute economic profit. That's a whole nother conversation and another video in itself. So be sure to put your comments down below if you want me to do a video on that and you want me to explain how to compute economic profit as well, right?

So any feedback you have along the way, drop it down in the comments because that helps me to plan the next set of videos. All right, so let's look at return on invested capital again and I'm gonna show you how to relate it back to strategy. And this is how I used to run companies and grow them as a CFO.

So remember it's NOPAT divided by invested capital. So if we just break down this formula into its component parts, you have two things. You have NOPAT margin, right? And then you have over here, invested capital, I'll abbreviate, turnover, all right? So let me prove this out here, do the long formula. To figure out your NOPAT margin, you basically take net operating profit after tax and you divide it by revenue, right? And that'll give you your margin as a percentage of revenue. To figure out your invested capital turnover, you just take revenue divided by your invested capital.

So remember math from back in the day, you just take revenue, revenue and you cancel that out. That's how you end up with the same formula up above. I just did the long math and broke it into its component parts. I did that because I want you to understand how this helps you to evaluate whether your strategy is working and this is really important, okay?

Because you don't want to have a strategy in your business. You're like, yeah, we're checking the boxes. We're doing all these initiatives. We're completing these actions. We're measuring these results. It's good, but in fact, it's not producing a high return on invested capital.

Right, so how do we know if strategy is working? Well, if we go back to teachings from Michael Porter, he wrote a book called Competitive Strategy back in the day. He's the grandfather of strategy, Harvard professor, super smart individual. He talks about generic strategies and there are three we're gonna really talk about two. One is cost leadership and this is when you're pursuing a cost leadership strategy and your costs are lower than your competitors and therefore you're able to make higher margins because your cost structure is in check. You're really efficient with your cost. So think about Walmart, for example. They pursue a cost leadership strategy and then we have differentiation. I'll just abbreviate.

Now, differentiation is when you have a different product, a unique product in the marketplace and the key here is that it's unique and your customers are willing to pay a premium for it because they actually care. I've worked with some companies are like, yeah, our product's totally unique, we're different and they try to play off that, but it's like, yeah, your customers are price sensitive. So you really, you think you're pursuing differentiation but you're really straddling between the two and it's terrible.

The other generic strategy is focus. We're not gonna get into that today. I just wanna focus on these two here. When you think about differentiation, think about like Louis Vuitton, Prada, like luxury brands especially, they're really good at differentiation.

Okay, coming back here. When you're evaluating your strategy, if you wanna know whether you're pursuing a cost leadership strategy effectively or a differentiation strategy effectively, then you can ultimately look at your return on invested capital. And if you are earning a high return on invested capital because of your NOPAT margin, that means you are pursuing a differentiation strategy. If you're earning a high return on invested capital because you have a high invested capital turnover ratio, that means you are effectively pursuing a cost leadership strategy.

Okay, so let's just put some numbers to this. Let's just say you have a 30% net operating profit after tax margin, a profit margin, right? It's 30%, it's high. And your turnover ratio right here is 2X. That means your return on invested capital is being driven by this higher number, the 30%, and you're pursuing differentiation.

Now let's just imagine you have net operating profit after tax. Your margin is 12%. But your invested capital turnover is 6X. This number right here is what's driving it. And that means you are effectively pursuing a cost leadership strategy.

Now, what if both of your numbers are low? Well, if both of your numbers are low, that means I'm sorry, but you may not have an effective strategy or you may have no advantage at all in the marketplace. And likely, you're earning a return on invested capital that's below what you could be getting out of the S&P 500.

All right, so that's how I think about strategy and finance. Remember, you have strategy over here and you have finance over here and you need a bridge, these two. This is my little bridge. Maybe we have a nice little like river. I don't know why the river is red, but here's a little river with some boulders, right? You have this water going underneath it. That's your cashflow coming underneath the bridge.

But really you have strategy and finance here. You wanna drive high cashflow because great companies are those that have stable, healthy cashflows. And in order to do that, you need to have an effective strategy and you have to know your numbers to determine whether or not that strategy is actually working.

All right, that's what I have for you today. I just wanted to point out how return on invested capital works, why it's important to monitor it in conjunction with profit and cashflow and how to tie it back to strategy so you can know whether you're pursuing a cost leadership strategy, a differentiation strategy, or whether you have no advantage at all.

If you need help with any of this in your business, you could always reach out and find me at Coltivar.com. And just remember, leave your comments down below so I know which topics you're most interested in so I can help you to become even more successful in business.

All right, until next video, take care of yourself. Cheers.