All return on capital metrics help us to assess the level of earnings generated by a defined amount of capital. Return on invested capital is an important metric when assessing the operations of a company. This metric is really asking the question, how much profit is the company generating for each Dollar of total capital invested in the company? Return on capital is calculated by dividing NOPAT by the book value of invested capital. But what do we mean by these terms? Well, NOPAT is the net operating profit after tax, so it's calculated by multiplying the earnings before interest in tax by one minus the effective tax rate. The book value of invested capital includes all the financing items in the balance sheet for a simple business that would reflect equity plus net debt. But why net debt? Remember that we view cash as part of the business financing as it's not tied up in the operations, and it could be used to pay down debt if needed. So we deduct cash from debt in our calculation of invested capital. In practice, there are two different ways to calculate invested capital. The first way is to use book values at the start of the year. We sometimes refer to this as return on opening capital. The second way is to calculate the average amount of invested capital for the year. That's the average of opening and closing invested capital, and we refer to this as return on average invested capital. Both of these methods are valid ways of calculating return on invested capital as long as the same method is being applied consistently throughout our analysis and forecasts.

Whenever we use return measures, we do need to ensure consistency between our numerator and denominator. Note that invested capital includes equity and debt net of cash. This ensures that the denominator includes all capital, which is not tied up in the operations of the business. In turn, we compare this to NOPAT and that reflects the after tax earnings generated by the operations. This NOPAT can be used to pay returns to the investors in the company. That's the debt and the equity investors. So we have consistency between our numerator and our denominator.