What is One of the Best Measures of Business Performance?
Jul 12, 2016
Answer: Return on invested capital, or ROIC. In essence, it is cash flow divided by the total capital (debt and equity) invested in the business. ROIC can be used to measure the historical performance of a business unit or an entire company. Some organizations like to measure ROIC relative to a specified peer group over a three year period, and may include the metric in a long-term incentive program for executives.
The ROIC model is often used to assess the value creation capabilities of a firm. A high ROIC level, especially relative to a company’s peer group, indicates strong financials and excellent management. However, be careful to avoid unintended consequences. Like many accounting measures, ROIC can be manipulated by reducing capital expenditures, cutting advertising and product development costs, and ignoring growth possibilities- all of which may lead to long-term value destruction.
Economic Value Added or EVA is another strong performance measure, derived in part from ROIC. EVA is defined as ROIC less the company’s Cost of Capital. Companies earning less than their Cost of Capital usually cannot create value unless ROIC is above their Cost of Capital. EVA tells us that it is profitable growth that creates value, not just any growth.