Return on Invested Capital (ROIC) is the word every investor and for-profit organization loves to hear. Yet, while everyone knows it, few understand its true meaning and role in making a business successful. As a result, many companies generate revenue, but few become profitable.
You are burning candles at both ends, yet your profits are peanuts. But you are optimistic that things will smoothen once a process is in place. However, things remain unchanged after years of slogging. Your business model is not delivering the returns you expected. The problem could be anything – the cost, the price you charge for your goods or services, subsidies –or nothing.
The ROIC differentiator
There are many cases where two companies doing the same business, having the same clients, and charging the same price, have different profit margins. The reason for the difference is the ROIC. The textbook definition of ROIC is the net profit you earn from the investment you make.
ROI = Revenue – Cost X 100
But ROIC plays a more significant role than the above formula. In this article, we will look at the role of ROIC in business. Then, we will elaborate on how business financial analysis can make a difference in your ROIC.
When Should You Consider ROIC?
Famous investor Ben Graham said, “price is what you pay, and value is what you get.” ROIC is a financial ratio that helps you determine the actual value of your investment. You can use ROIC at a business level, project level, and even at a purchase level. It is not just the business owner who should consider ROIC. Every party having a financial interest in the venture should consider ROIC. For instance:
- Financial officer – If you pitch your business to a banker or venture capitalist for funding, you need to calculate ROIC.
- CEO – You need ROIC to determine which projects to take up and which projects to pass.
- Sales professional – If you pitch a client, you need to show the ROIC your product/service will offer.
- Operations manager – You need ROIC to map the project’s budget and identify gaps eating up money.
Once you establish the ROIC for the project or business, you can make effective business decisions early. For instance, ABC construction has three projects, but it only has the resources (cash, staffing, and equipment) to take up two.
|Particulars||Project A||Project B||Project C|
Project B and C or Project A and C will earn ABC the same dollar profit. But the ROIC will be higher in the second combination (60%) as against the first (50%). The business that makes decisions using ROIC as a parameter has a higher chance to improve profit.
This was the business aspect of ROIC. Now, we will move to the accounting aspect.
What’s Your ROIC?
There are two types of ROIC, anticipated and actual. The goal is to narrow the gap between the two. The most common mistake businesses make they set an over-optimistic anticipated ROIC. As a result, they fail to factor in the cost of rework, delays, or the cost of capital. Hence, profit margins fall when the business faces some crisis that leads to delays.
ROIC is a dynamic ratio. It will keep changing with time. Your financial analyst will help you factor in necessary variables when calculating the anticipated ROIC. Establishing the ROIC is just the first step. Next, you need to track the business’s performance by comparing it with the actual ROIC. This will help you make necessary alterations to your business plan.
For instance, Joey sells 100kg Apples every month that he grows at a farm. His cost is $1/kg, and he sells them for $4.50/kg. His transportation cost is $200, and he pays $500 interest on the $10,000 capital he put in the business. His ROIC is:
ROIC = $4,500 – ($1,000 + $200 + $500) x 100
ROIC = 28%
How a business analyst can help you reduce ROIC
ROIC is dynamic because the elements are dynamic. In the above case, Joey accepts a lower ROIC. However, the rising gasoline prices keep eating up his profits and the gap between the anticipated and the actual ROIC increases.
In this case, a professional business analyst will identify the areas where you can cut costs without impacting operations. For instance, the government might offer subsidies that Joey may not be aware of, but the expert will be. The expert can help Joey secure the subsidy and enhance the ROIC. This is just one scenario.
In reality, a business has many variables. A business analyst can help you make realistic anticipated ROIC and identify opportunities (like subsidies) and gaps early.
Contact Glenn Graydon Wright LLP in Oakville for Guidance on how to Understand the Role of ROIC in your Business
Contact our experts to help you work smart, not hard and improve your ROIC. The expert team at Glenn Graydon Wright LLP can work with you to analyze your business’ financial situation. Contact us by phone at 905-845-6633 or reach out online.