Finance Definitions: Return on Invested Capital

Finance Definitions: Return on Invested Capital

As we return to our stock term definitions, we come to another integral term: Return on Invested Capital (ROIC). This term can help investors determine if a company is using its money well to churn out returns. However, the ROIC is a little deeper than this; to really grasp ROIC in its entirety, we have to define "capital" and "cost of capital." Let's look at each of these and at ROIC a little more in depth.

From the Top: Capital

First, let's begin by defining capital. Basically, capital is any and all assets that have a cash value. Obviously, this means that any cash on hand in the company is considered capital, but other items can be lumped into this definition as well. Equipment, machinery, buildings, projects in the works and any other items of value that could be sold for cash are also considered capital.

Unfortunately, although defining capital is quite simple, applying it to different businesses isn't always as cut-and-dried. Businesses can list many items in their possession as capital, so the return on investment capital isn't entirely clear. We'll get into that in a little while. First, let's move onto the WACC.

Cost of Capital

The next term we need to look at quickly is the weighted average cost of capital, or the WACC. We'll define this rather generally because we'll cover it in detail at a later date. For now, the general definition will help us apply it to the ROIC. So here it goes: generally speaking, the cost of capital is the total amount of money that it would take to fund new projects, and it includes both proposed business debts and equities in its equation.

Putting it all Together

Now that we've defined capital and the cost of capital, let's get back to the return on invested capital. As we generally discussed in the intro, ROIC helps us as investors see if a company is using its money wisely to produce good returns. Although the ROIC number in itself is important, comparing the ROIC and the WACC can really help paint a picture on the efficiency with which the capital was used to produce returns.

As mentioned above, though, the definition of capital can be a little blurry, and this number could potentially be skewed by a large one-time sale of goods or some other transaction. It's therefore important to look at more than just the ROIC when comparing stocks; determining the company's overall health is often best accomplished by comparing multiple valuations and following company news before purchase.

That's it: return on investment capital at its finest. Follow along as we tackle more finance and stock definitions in the future!

MoneyCone's picture

MoneyCone wrote:

Mon, 04/02/2012 - 19:24 Comment #: 1

Fine explanation of ROIC!

Christa Palm's picture

Christa Palm wrote:

Tue, 04/03/2012 - 18:06 Comment #: 2

Thanks, MC!