Imagine two HVAC companies operating in the same city. Both generate $1 million in annual revenue, produce $100,000 in operating profit and have a 10% profit margin. On paper, they appear equally successful
But the first company requires only $250,000 in vans, equipment, inventory and working capital to operate. The second requires $1 million. They earn the same profit, but one needs four times as much money to produce it
They are not equally good businesses
Profit does not tell the whole story
Business owners naturally focus on revenue, profit and margin. These numbers matter, but none tells us how much money had to be invested to produce the result
A company can generate an impressive profit while requiring an even more impressive amount of capital to earn it. Another company can produce the same profit with fewer vehicles, less equipment, lower inventory and faster customer payments
The income statement may make the companies look similar. The capital required to operate them reveals the difference. This is what return on invested capital, or ROIC, helps us understand
ROIC = Operating profit ÷ Invested capital
In plain English, ROIC asks:
“For every dollar tied up in the business, how much operating profit comes back each year?”
Return to the two HVAC companies
The first HVAC company produces $100,000 of annual operating profit from $250,000 of invested capital. Its ROIC is 40%, meaning every dollar invested produces approximately 40 cents of annual operating profit
The second produces the same $100,000 but requires $1 million of invested capital. Its ROIC is only 10%, meaning every dollar invested produces approximately 10 cents
Both companies have the same revenue, profit and margin. But the first uses its capital four times more productively
“Profit tells you what the business earned. ROIC tells you what the business needed to earn it”
This difference affects what happens next. The first company may be able to fund new hires, enter another market or return money to its owner using internally generated cash. The second may need more loans or owner investment every time it grows
The second company is not necessarily a bad business. Its larger fleet and inventory may allow it to perform specialized work that competitors cannot. But those assets need to produce enough additional profit to justify the money tied up in them
What counts as invested capital?
Invested capital is the money tied up in the assets required to operate the business. For an HVAC company, that might include service vans, tools, equipment, spare parts and the working capital required to pay technicians and suppliers before customers settle their invoices
For a restaurant, it might include the kitchen, renovations, furniture and inventory. For a retailer, it may include the store buildout and products sitting on the shelves
The exact calculation can become technical, but most owners do not need to begin with a perfect accounting answer. A reasonable estimate of the money currently tied up in equipment, inventory and working capital can already reveal a great deal
“The question is not what the business cost to start. It is how much money the business needs to keep working”
Margin and ROIC answer different questions
Profit margin measures how much profit the company retains from each dollar of revenue. If the HVAC company produces $100,000 of operating profit from $1 million of revenue, its operating margin is 10%
ROIC measures how much operating profit the company produces from each dollar invested in the business. Margin tells us about the economics of the company’s sales, while ROIC tells us about the operating system required to produce those sales
This explains why two companies can have identical margins but very different returns. One may need only a few vans and limited inventory, while the other requires an expensive facility, specialized equipment and substantial working capital
Growth can weaken returns
Now imagine the second HVAC company invests another $500,000 in vehicles, equipment and inventory. The expansion increases annual operating profit by $25,000. Profit has increased, which sounds like success. But the new investment is producing a return of only 5%
$25,000 additional operating profit ÷ $500,000 invested = 5% return
The company is larger and more profitable than before, but each new dollar is producing a weaker return. Growth can increase revenue and profit while making the business less efficient with capital
“A larger profit does not automatically mean a better business”
The right question is not simply whether an investment will increase sales. The owner must ask how much additional profit it will produce relative to the money required
Make every dollar work harder
Once owners begin thinking in terms of ROIC, they start seeing opportunities that revenue and profit alone can hide. An underused vehicle is capital that is not producing enough return. Excess inventory is cash trapped on a shelf. A slow-paying customer increases the amount of money required to finance the business
A company can improve its return without finding a single new customer. It might sell underused equipment, reduce excess inventory, collect invoices faster or increase the utilization of assets it already owns
ROIC does not tell owners to stop investing. It helps them distinguish productive investment from expensive growth
“The objective is not to use the least capital possible. It is to make every dollar invested work harder”
One caution matters for owner-operated companies. If an owner works full time but takes little or no salary, reported profit may appear stronger than it really is. An honest estimate should account for what the company would need to pay someone else to perform that work
The ROIC calculation does not need to be perfect to be useful. Even a rough estimate can show whether the business is using money productively and whether its next investment makes economic sense
Your Better by Monday action
Choose one major investment your business made during the last two years, such as a vehicle, new location, piece of equipment, inventory purchase or software system. Estimate the total amount invested and the additional annual operating profit it now produces. Then use this calculation:
Estimated return = Additional annual operating profit ÷ Total investment
If you invested $100,000 and the investment now produces $20,000 of additional annual operating profit, the estimated return is 20%
By Monday, decide whether the investment is producing the return you expected. If it is not, identify one way to improve it, such as increasing utilization, raising prices, reducing inventory or eliminating an unnecessary cost. Do not ask only whether the investment increased revenue. Ask what every dollar invested is producing
~Alex
Until next time …
One practical way to improve your business each week