All you need to know about incremental ROIC
Incremental ROIC or return on incremental invested capital (ROIIC) is a key measure of a business’s financial performance and quality. This ratio indicates the efficiency and profitability of capital investments (whether going or already) made in a company. This is an extremely important quota, especially if you intend to invite investors to invest in your business.
In this article, we will discover what an incremental ROIC is. We'll also find out how to calculate the incremental ROIC. Finally, we will analyze some examples of incremental ROIC to make you understand more how to manipulate it in real situations.
Let’s get into it now!
What is incremental ROIC?
The incremental ROIC, which can also be referred to as the “return to whole assets ratio”, is a long-term return value that gives an indication of how efficiently a company uses its capital to generate profits, in particular, indicating the earning profit generated by each dollar invested.
In other words, ROIIC indicates how a business uses the assets approach at its disposal, and it is, therefore, a good indicator to assess the profitability of an investment taking into account its initial cost and its return.
While incremental ROIC is often used to analyze a past situation, it can just as easily be used to estimate the possible outcome of a future project, based on the information gathered beforehand to estimate possible savings and define a break even. The incremental ROIC can help operators foster the best projects requiring investment and quickly make the right decisions about investment approaches.
More generally, the return on incremental invested capital can be very different depending on the type of economic activity. Some industries with large capital will have relatively low incremental ROIC because they require expensive infrastructure to operate, unlike others, in services in particular, which require little capital.
How to calculate the incremental ROIC?
Incremental ROIC is calculated by dividing a company's operating gain by its invested capital (invested capital = all of the company's assets, excluding debt). The formula is as follows:
ROIIC = operating profit / invested capital
Since benefit before depreciation, interest, and tax is actually the difference between income and expenses (excluding depreciation expenses, interest payments, and tax payments), the (ROIC) is essentially the ratio between net income and net benefit (entire assets minus current liabilities).
The most common purpose of calculating the return on incremental invested capital is to validate the potential savings of a proposal. The larger the proposition or change, the more difficult it is to determine the ROI accurately. The advice we offer you concerns small and medium proposals. For larger proposals scale, seek the assistance of an analyst or any other accounting specialist to determine the ROI of your project with exactness.
In a very competitive industry, such as the restaurant industry, incremental ROIC is a better indicator of the commercial situation than net income. In a viable business environment, the ROIIC must always be higher than the interest rate at which the company borrows, otherwise, all amounts borrowed will contribute to reducing shareholders' bottom line.
The importance of the rate (ROIC) as an indicator of a company's economic viability is that it is more difficult to attract private investment into a company with a low return on invested capital.
Example of incremental ROIC
Model of calculating the return on incremental invested capital that is planned to be invested in a business:
You are planning to open a restaurant with 70 seats. You plan to make an investment of $ 5,000 per place for the start-up of this restaurant. You plan to invest a sum of $ 350,000 (70 places X $ 5,000 per place) in your restaurant.
You plan to invest in equipment and rental improvement an amount of $ 3,000 per space, or $ 210,000 (70 spaces X $ 3,000 per space). An amount of $ 2,000 per space, or $ 140,000 will be set aside for your starting working capital.
You expect to get a Small Business Loan (PEP) of $ 189,000 (which is 90% X $ 210,000). The difference between the required amount of $ 350,000 and the borrowed amount of $ 189,000 is $ 161,000. This amount of cash comes directly from your personal wealth.
In the first year of operation, you expect to earn $ 10,000 per space for entire sales of $ 700,000. You expect to achieve a net benefit before tax of 3.8 percent in your first year of operation. Your net benefit before tax will therefore be $ 26,600. The benefit before depreciation, interest, tax is $ 61,600.
Your estimated ROIIC will therefore be $ 61,600 ÷ ($ 350,000 - $ 0) = 17.60%.
Why is incremental ROIC important?
The importance of return on incremental invested capital to the business
What is called invested capital is not just the cash acquired by the business, but the totality amount needed for the capital of the business. If companies invest to increase their capacity to produce the best product and service for their customer, they see their growth increase. These investments, whether in new machinery, technology, or stock, for example, are expected to generate additional income, known as “returns on investment”.
The importance of return on incremental invested capital for investors
Investors of course utilize incremental ROIC to assess a company's performance after paying off equity and debt and check the rate of return on the capital they have invested. This allows them to know whether the company is likely to generate maximum income with the employment of the funds invested.
Competitive advantage assessment
Companies may be called upon to use ROIIC to assess their value and market positioning relative to their competitors in the same field of activity. It is considered that the value has been added if the ROIIC is greater than 2%. On the other hand, if it is less than 2%, the capital invested by the company is considered to have neither added value nor generated a return.
Key takeaway
In conclusion, incremental ROIC is an essential element to take into account in order to improve the capacity of the company. Its calculation must be carried out regularly and very precisely to obtain exact information, allowing to carry out good and solid investment projects.
The calculation of incremental ROIC should be done before starting a business to estimate the rate of return on the capital expected to be invested in the business. In order to assess the financial situation and efficiency of the company, this calculation should also be made subsequently at the end of each year of operation.