What is meant by reinvestment rate?
Reinvestment rate means the rate at which management of a company reinvests the net profit achieved in a year back into the same business. The term “rate” means the percentage of net profit reinvested back to the business.
How to calculate the reinvestment rate?
If you want to find this ratio only for one year, you can find it simply by taking the amount of change in capital employed at the beginning of this year and dividing it by the net profit reported at the end of last year.
(Capital employed in this year – Capital employed in the previous year)/ Net profit of the previous year
The amount of change in capital employed can be identified from the balance sheet and net profit can be identified from the profit and loss statement from a company’s annual report.
Finding the reinvestment rate of a company for the last 10 years or so is a bit difficult to calculate but still very much possible if you are ready to learn and understand. So, here it goes
The formula to calculate the reinvestment rate for “X” years is
Change in capital employed in last “X” years / Cumulative earning in last “X” years
“X” is the number of years that you are considering in the calculation
For example, assume that “X” years is 9 years, and the period to calculate the reinvestment rate is from 2013 to 2021
Here, we are trying to find out how much of the total sum or cumulative profit of the company earned during the period from 2012 to 2020 (9 years) are reinvested back to the business in the period 2013 to 2021(9 years).
If you refer to the below-given table. Capital employed in the business at the beginning of the financial year 2012 was Rs. 500 Cr. and the company reported a net profit of Rs. 100 Cr. at the end of the financial year 2012. Out of 100 net profit, the company took Rs. 90 Cr. and reinvested back to the business and hence the capital employed in the year 2013 changed to Rs. 590 Cr. (Rs. 500 Cr. + Rs. 90 Cr.). The same process continued again. In 2013 out of Rs. 122 Cr. profits reported Rs. 111 Cr. is reinvested back to the business and that changed the capital employed in the year 2014 to Rs. 701 Cr. (Rs. 590 Cr. + Rs. 111 Cr.)
|Year||Capital employed in the business at the beginning of the financial year||Net profit at the end of the financial year||Net profit from the end of each FY reinvested back to the business|
Based on the above table, the total change in working capital in 9 years from 2012 to 2021 is Rs. 1338 and the sum of net profit created in 9 years from 2012 to 2020 is 1451. If you take the reinvestment rate by dividing Rs. 1451 with Rs. 1338, you will get the reinvestment rate is 92%. Meaning, for every 100 bucks created as net profit, Rs. 92 is reinvested back to the business. Look at the table given below.
|Change in working capital between in 9 years from 2012 to 2021||1338|
|Sum of net profit created in 9 years from 2012 to 2020||1451|
|Sum of net profit at the end of each FY reinvested back to the business||1338|
Assuming that you understood how the reinvestment rate is calculated, let us try to understand what way you should look at a company having a high investment rate.
Advantage of high reinvestment rate
What can a company do using net profit? They can
- reinvest the amount back into the business,
- issue dividends,
- pay off debt or
- use the amount to buy back shares
Every option has its need and benefits which I am not going to explain in this post. But when the company is reinvesting a major chunk of its profit back into its business, that shows the growth potential of the company and that shows the potential future earnings growth.
When a company reinvest its profit at a high rate and on that reinvested capital if the company is able to maintain a healthy ROCE, that is what an investor must look for.
For a company to grow, they need to invest more in capital expenditure (CAPEX) and operations expenditure (OPEX). By reinvesting the profit back to the business, the company can meet the expenses for growth of the business without taking debt or without issuing more shares to the public (which will cause equity dilution).
Hence, considering all other ratios as equal, if I have options to invest in a company, I go for the one with the highest reinvestment rate.