The return on invested capital compares a firm’s return on capital to its cost of capital. If the comparison yields a positive number that exceeds the current inflation rate, this means that the firm is doing a good job of allocating its funds to projects that yield a reasonable return. Conversely, if the return on invested capital is negative, this means that the company is destroying it own capital. A business that can consistently generate a positive return on invested capital is well-managed and so is more likely to be a reasonable investment choice for an investor.
The return on invested capital is calculated as follows:
The calculation should be based on the operating results of a business, excluding the financial effects of all one-time or unusual events. This approach yields a truer picture of the ability of a firm to profitably invest funds in its operations.
This calculation is most important in industries that require a large amount of capital spending, such as oil refineries. In a business that requires little capital spending, such as a services business, the calculation is not a critical issue when evaluating an organization’s performance.