Return on invested capital, or ROIC, is a financial-performance forecasting tool that Fool analysts use regularly. We believe that looking at economic earnings -- free cash flow, or ROIC minus a charge for the use of that capital -- produces a much better view of the economics and value of a company than just looking at earnings growth would. After all, earnings growth comes at a price in many instances, whether by way of heavy investment in working capital, fixed assets, or the issuance of stock to acquire other businesses.
This series is an introduction to how ROIC is calculated. We believe that understanding ROIC is as fundamental as learning how to calculate earnings per share or figuring out a company's current ratio. It's not profit margins that determine a company's desirability; it's how much cash can be produced by every dollar that shareholders or lenders invest in a company. Measuring the real cash-on-cash return is what ROIC seeks to accomplish.
ROIC is sort of like return on equity but greatly improves upon it. ROE -- net income divided by the average shareholder equity in use over the period being examined -- takes into account in the denominator only the net assets a company has in use. A major problem with this calculation is that certain liabilities mandated by generally accepted accounting principles, or GAAP, reduce the amount of resources at the company's disposal in the ROE equation. Depending on the circumstances, though, these liabilities should not be counted as a reduction in the capital working for the benefit of shareholders. They should be counted as an addition to capital in use by shareholders. That being the case, moving an amount out of liabilities and into owners' equity necessarily increases the denominator of the ROE equation and thus lowers the company's ROE.
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