The Debt Factor- ROIC

Last Updated on March 3, 2020

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:

Equity Capital is the money contributed by the promoters and the other shareholders. Equity holders are basically the owners of the company.

Debt Capital:

Debt Capital is the money borrowed from banks/ other lenders carrying an interest charge on it.

Hence, the total capital of the firm is the sum of this equity capital + debt capital.

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 investing in a company, watch out for companies having a high debt. Due to its capital structure being highly leveraged(high debt) its ROIC is very low.

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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