The Debt Factor – ROIC
Why should you look at a company’s ROIC?
Let s start with first answering what is ROIC?
ROIC is a financial measure that quantifies how well a company generates cash flows relative to the capital it has invested in the business. Here, the investment represents pool of funds supplied by its shareholders & the lenders.
ROIC – Earnings before Interest & Depreciation/ Total Capital
Let’s see what does Total Capital mean??
Total Capital = Equity Capital + Debt Capital
Equity Capital is the money contributed by the promoters and the other shareholders. Equity holders are basically the owners of the company.
Debt Capital is the money borrowed from banks/ other lenders carrying an interest charge on it.
Now, why are we stressing on ROIC here??
ROIC is a true measure of the company’s returns and gives a fair picture of the profitability as it includes the debt component. Companies can raise a lot of debt to increase their ROE (return only on the equity capital excluding debt); hence showing a rosier picture of the return, but the main factor that needs to be taken into consideration is the Debt.
Let’s look at an example:
Mr. A invests Rs 3 Crore in a portfolio of stocks, out of which he invests only 1 Crore of his own & raised the rest through debt from banks at 12% interest charge. In the next year the value of his portfolio appreciated to Rs.3.60 Crore. His return hence is, (60 lakhs less 24 Lakhs for -interest charge) = 36Lakhs. If we look at his ROE it is 36%, (i.e. 36 laks on Rs.1Crore) but if you look at his ROIC taking the debt factor into consideration it is 20%.
Hence, while looking at a company’s returns & its capability to generate further returns we must give stress on its ROIC figure as well which shows a fairer picture of the company’s capability.
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