UNDERSTANDING ROIC

By David Coit on Jul 11, 2017
Return on Invested Capital

(Re-posted with permission from the author and Vertess)

ROIC is the cash flow a company returns to the owners of its capital (i.e. debt holders and equity owners) as a percentage of total invested dollars.

For example, suppose you bought a durable medical equipment (DME) company for $100,000 and you personally put up $50,000 and your brother lent you the other $50,000, with the understanding that you would pay him $3,000 a year in interest.

If your DME made $20,000 after expenses the first year, your firm's ROIC would be 20% ($20,000 on $100,000). Your ROIC would be 34% ($17,000 on $50,000) and your brother’s ROIC would be 6% ($3,000 on his $50,000).

However, if your DME only made $3,000 after expenses the first year, your firm's ROIC would be 3.0% ($3,000 on $100,000). Your brother's ROIC would still be 6% ($3,000 on $50,000) but your ROIC would be 0% ($0 on $50,000), which would not be good for you, of course.

Taking that example further, suppose in the second year, you decrease your operating expenses by $2,000, and increase your revenue by $10,000. In that case, your firm would be making $32,000, so the ROIC for your firm would be 32% ($32,000 on $100,000), your own ROIC would be 58% ($29,000 on $50,000) and your brother's ROIC would remain at its fixed rate of 6% ($3,000 on his $50,000).

Now, let's suppose you convince your brother to accept only $1,000 a year in interest. In effect, you've restructured the loan so that his ROIC is 2% ($1,000 on his $50,000). If you still made $20,000 after expenses, your firm's ROIC remains at 20% but your ROIC goes up from 34% to 38% ($19,000 on your $50,000).

This may seem like a lot of numbers, but the example is important because, if and when you sell your business, potential purchasers will look at the ROIC to determine whether your DME is worth their investment dollars.

Therefore—and this is important—it is very much in your interest to increase your company’s ROIC. In general, there are three ways to do this:

  1. Increase your revenue growth
  2. Decrease your operating expenses
  3. Increase your operating margins.

Ideally, you want to restructure your business and business model to do all three. Here are some classic ways to accomplish this:

Grow Revenue

  • Introduce new products/services to your existing market
  • Expand your customer/patient base in your existing market
  • Differentiate your product/service offerings to earn price premiums (Focus on such things as higher quality outcomes, more innovation, branding, and customer lock-ins)
  • Expand into other markets not currently being served
  • Increase patient health outcomes per dollar spent, thereby creating customer loyalty
  • Acquire another company/practice

Decrease Expenses/Increase Operating Margins

  • Invest in high return ancillary products/services, such as an urgent care center, med spa, physical therapy, in-house pharmacy, radiology, and/or laboratory testing
  • Use financial leverage as investment capital for higher return investments
  • Reduce unnecessary or excess expenses by outsourcing non-core functions, creating a paper-less office, and right-sizing staff to optimize customer/patient experience/results
  • Take advantage of innovative methods, unique resources, scalability, and economies of scale to drive down cost per customer/patient while maximizing operational efficiencies
  • Reduce administrative errors, automate repetitive activities, eliminate redundant tasks, and improve organizational knowledge through education and training
  • Create integrated customer/patient care teams that specialize in specific treatment protocols

This list is not exhaustive, but it does give you a good place to start. As the healthcare industry continues to experience dramatic changes, owners who focus on these fundamentals of value creation will not only consistently outperform those who do not, but also secure the highest price for their practices, if and when they sell.

 

If you want to find out what your healthcare company is worth and what you can do to increase its value going forward, please email me at dcoit@vertess.com.

David Coit, Jr., DBA, CVA, CVGA, CMAA

480.256.0978