Capital Allocation Part III: Return on Capital

We're wrapping up a 3-part series (here's part I and part II) on capital allocation – the effective use of profits and cash flow – with a concept called Return on Invested Capital (ROIC). [Sometimes just called return on capital or ROC.]

First, a quick reminder of our balance sheet – we buy or build assets for the purpose of driving increased revenue and we fund those assets in 2 ways:

1. Using debt from loans and/or suppliers (trade credit); and
2. Using equity through retained earnings (profit) and/or more equity

What is ROIC?

With this metric, we're measuring the financial return we're getting on the capital in our business. The formulas are pretty simple:

Investment researcher Michael Mauboussin has a great analogy for ROIC – the old saying that you need to “spend money to make money.”

In ROIC, the “spend money” part of that saying is Invested Capital (the sum of debt and equity in the business) while the “make money” is operating income before interest. (We're using a pre-tax and pre-interest measure of earnings here.)

Why this should matter to you

At the end of the day, ROIC is just a financial metric like the dozens of others out there. ROIC gives us a measure for how effective we're using capital (cash). A higher ROIC usually means more money in the owners' pocket and a more valuable business when it comes time to sell. Remember: if you own a business, there's a good chance it represents a huge portion of your personal net worth.

How to use this...

As always, a measurement is only useful if we can do something with it. Here are some tips and tactics when it comes to using ROIC in your company:

• Add this metric to your ratio scorecard – At Profit Mastery, we preach using a ratio scorecard to read your numbers. This one is worthy of a spot on your report card.
• Benchmark your ROIC – Each industry has a different financial profile (margins, capital needs, etc.) so ROIC benchmarks can also vary. Here's a table highlighting benchmarks by industry (note these are after tax comparisons).
• Target 30-50% ROIC or higher – This target can change as you scale but this is a good "rule of thumb." Smaller/newer businesses could be even higher at 100%+ while larger/established businesses gravitate toward 15-20%.
• Challenge yourself to maintain profitability with minimal capital – Treat this as a creative challenge to cut back on capital in your business... optimize supplier terms, shift supplier payments to CC, take deposits upfront, invoice daily or weekly instead of monthly, lease vs. buy, etc.
• Think of your ROIC when making business investments – Acquiring a business? Purchasing a piece of equipment? Borrowing money? Make sure the capital for those investments leads to an equal-or-better return than your ROIC!
• Clean up your accounting for easy ROIC calculation – Keep interest and depreciation expenses below your operating income line to make this a simple calculation each quarter, year, etc.

Here's an example scenario:

• Start with the balance sheet, you'll notice there are 2 methods for calculating invested capital and they are mathematically identical. What's the point there? It highlights where you can "play" with your capital (i.e. increasing A/P in lieu of debt will lower the capital in your business).
• Operating income should be pre-interest – we're looking for profits available to all sources of capital (both debt and equity providers).
• This sample business has an ROIC of 43% (right in the targeted zone!)

Key takeaway — This is an advanced concept so don’t fret if you’re feeling overwhelmed. To sum up this 3-part series:

1. Capital allocation is how we use our profits and cash flow (buy assets, pay down liabilities, equity distributions);
2. Sources and uses of cash flow tell us where our money came from and where it went over various time periods (our capital allocation mix); and
3. ROIC is a metric to measure how effectively we’ve put that capital to work (business quality and value).