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There are different factors investors and businesses must consider before making and committing to an investment—one of the most important being the return. Returns are the difference between the cost of the investment and the value generated after the investment period. Several ways exist to determine different types of returns, including the return on incremental invested capital (ROIIC). Although not a commonly known metric, ROIIC can tell you how well a company is using its capital to generate profits. In this article, we explore what it means and how you can calculate it.
Key Takeaways
- Return on incremental invested capital determines how well a company uses its deployed capital.
- ROIIC is an extension of return on invested capital, which is an extension of return on investment.
- You can calculate ROIIC by dividing the constant rate incremental operating income (plus depreciation and amortization) by the constant rate-weighted average-adjusted investment capital.
What Is Return on Incremental Invested Capital (ROIIC)?
Return on incremental invested capital is an operating performance measure calculated as a percentage. As the name suggests, it is the incremental return earned on a capital investment. As such, it determines how well a company uses its deployed capital. It can also be used to provide insight into how sustainable a company’s business model is over the long term.
It is an extension of return on investment capital (ROIC), which itself is an extension of return on investment (ROI). ROI measures a company’s profitability by dividing income by stock equity plus debt while ROIC tells investors how efficiently that profitability is earned per dollar of company capital.
ROIIC narrows the focus even further and shows how profitable each additional unit of capital investment could be. It is used in similar ways to the incremental capital-output ratio. A company uses its ROIIC to express the relationship between its capital investments and the rate of return (ROR) on those investments.
Financial metrics like return on incremental invested capital and return on investment are often expressed as a percentage.
Calculating Return on Incremental Invested Capital (ROIIC)
ROIIC is calculated by dividing a company’s constant rate incremental operating income (plus depreciation and amortization) by the constant rate-weighted average-adjusted investment capital, according to the Securities and Exchange Commission (SEC). Note that the constant rate excludes the impact of foreign currency translation.
The denominator for the ROIIC equation needs to apply weights to each quarter in the period being evaluated, which is usually one or three years. For example, in a one-year ROIIC, each of the four quarters must have a different exponent applied to adjust for differences in levels of investment activities. If more cash investments were made in Q3 than in Q4, the weights should represent this.
The weighted results are then aggregated to produce a one-year adjusted cash figure. This should produce a more realistic reflection of how investments impact returns than a simple annual average. ROIIC can then be compared to the company’s weighted average cost of capital (WACC) to help determine whether to pursue a new project.
What Does a Company’s Return on Incremental Invested Capital Measure?
The return on incremental invested capital is a performance metric that helps businesses, analysts, and investors understand how well a company is using its deployed capital. Put simply, ROIIC measures the incremental return a company earns from capital investments and is expressed as a percentage. It can also be used to determine whether a company’s long-term business model is sustainable.
What Are Some Common Returns-Based Metrics?
Some of the most common returns-based metrics used in finance are return on equity (ROE), return on assets (ROA), return on investment (ROI), return in invested capital (ROIC), and return on capital employed (ROCE). Measuring returns is important because it can help businesses and investors gauge the viability of certain investments.
What Is the Ideal Return on Investment Ratio?
The Bottom Line
Return-based metrics can help guide businesses about how far their money is going. The return on incremental invested capital gives insight into how well a company can earn profits from its capital. The metric can be used to gauge whether continued investment in a project is worth it or if changes need to be made in a company’s business model. Investors can also use ROIIC, coupled with other return-based metrics, to compare different companies across the same sector to determine which ones may offer the best return.
