𝗨𝗻𝗿𝗮𝘃𝗲𝗹𝗶𝗻𝗴 𝗥𝗢𝗜𝗖 (𝗥𝗲𝘁𝘂𝗿𝗻 𝗼𝗻 𝗜𝗻𝘃𝗲𝘀𝘁𝗲𝗱 𝗖𝗮𝗽𝗶𝘁𝗮l)

𝗪𝗵𝗮𝘁 𝗶𝘀 𝗥𝗢𝗜𝗖 𝗮𝗻𝗱 𝗮𝗻𝗱 𝘄𝗵𝗮𝘁 𝗱𝗼𝗲𝘀 𝗥𝗢𝗜𝗖 𝗯𝗿𝗲𝗮𝗸𝗱𝗼𝘄𝗻 𝘁𝗲𝗹𝗹𝘀 𝘂𝘀 𝗮𝗯𝗼𝘂𝘁 𝗮 𝘀𝗲𝗰𝘁𝗼𝗿? — a common interview question.

A business creates value when the Returns on Invested Capital exceed the Cost of raising that Capital.
Consistently high ROIC (>> Cost of Capital) is a recipe of enormous shareholder value.
ROIC — also referred to as the measure of Quality of investment — is a function of
a. how efficiently capital is deployed ( measured as revenue generated per $ invested )
b. profitability

ROIC = Operating Profit (post tax) / Invested Capital

Re-arranging the formula

ROIC = Revenue / Invested Capital * Operating Profit (post tax) / Revenue
or
ROIC (pre-tax) = Capital Efficiency * Operating Margin

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Breaking down ROIC into Capital Efficiency and Operating Margin — tells us about sector characteristics.

Let’s look at these metrics for a few sectors.

Sector:
Capital Efficiency * Operating Margin = Pre-tax ROIC

🛒 𝗥𝗲𝘁𝗮𝗶𝗹:
Dmart 3 * 6.7% = 20%
(revenue of ₹3 per ₹ of invested capital * EBIT margin of 6.7% = pre-tax ROIC of 20%)
What does this tells us?
High capital turns (low capital intensity), low margins — since this is a volume business.

Do this breakdown for a luxury retailer!!

🏥 𝗛𝗼𝘀𝗽𝗶𝘁𝗮𝗹:
Kovai Medical 1.1 * 20.6% = ~23%
Narayana 1.3 * 18.3% = ~24%
Medanta 1.0 * 18.3% = ~18%
Capital intensive sector (low revenue per ₹ of invested capital), good margins

👩‍💻 𝗜𝗧 𝗦𝗲𝗿𝘃𝗶𝗰𝗲𝘀:
Infosys 2.6 * 20.7% = ~54%
HCL 2.2 * 18.2% = ~40%
Low capital intensity, good margins

🏍️ 𝗔𝘂𝘁𝗼𝗺𝗼𝗯𝗶𝗹𝗲:
Eicher Motors 6.6 * 26.2% = ~173%
Hero Motocorp 2.8 * 12.1% = ~34%
TVS Motors 1.3 * 11.9% = ~16%
Eicher being a premium player enjoys both low capital intensity and healthy margins vs mass players

𝗧𝗲𝗰𝗵𝗻𝗼𝗹𝗼𝗴𝘆:
Microsoft 0.9 * 44.6% = ~40%
Netflix 1.0 * 23.8% = ~24%
High investments into intangibles/goodwill leads to high capital intensity; healthy margins


You need to double click on
a. Invested Capital — fixed assets, working capital, intangibles, goodwill, others assets — identify which of these is a large number that’s impacting capital efficiency.
b. Operating Profits — cost of goods, SG&A, depreciation — identify which of these is driving low/high profits.
It will give you a sense of the sector/business


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Learning to interpret financial statements and ratios tells you a lot about a business.
If the above explanation helped then consider watching the below playlist to comprehensively learn hashtag#financialstatementanalysis beyond what is covered in textbooks: