What Is Return on Capital?
Return on capital (ROC) is a ratio that measures how well a company turns capital (e.g. debt, equity) into profits. In other words, ROC is an indication of whether a company is using its investments effectively to maintain and protect their long-term profits and market share against competitors.
Return on capital is also known as return on invested capital (ROIC).
How to Calculate Return on Capital
The goal of calculating return on capital is to determine how profitable a company’s operations are. It can be used to show investors or capital contributors how well the company is doing at turning invested capital into profit. Using the same formula over time will also illustrate whether a company’s performance is staying the same, improving, or declining.
Everything you need to learn how to calculate ROC (or ROIC) can be found on a company’s financial statements. More specifically, financial statements like the balance sheet and income statements allow companies to look more critically at factors such as debt, equity, dividends, and net income.
Return on Capital Formula
The return on capital formula is:
ROC = (net income - dividends) / (debt + equity)
In some instances, you may also see the ROC formula written as:
ROC = (NOPAT) / (invested capital)
What Is Nopat?
NOPAT (or net operating profit after tax) looks at a company’s core operations, net of taxes, and how well it’s faring in terms of income. Since both debt and equity count as capital invested towards the business, the formula above uses the term “invested capital.”
The Difference Between ROC and ROCE
Return on capital and return on capital employed (ROCE) are both valuable methods to measure how efficiently a company is operating as it relates its potential future growth. They’re often used together, but the difference lies in the primary measure in which they measure efficiency.
ROC looks at profits using invested capital (or equity of shareholders) whereas ROCE looks at all capital employed to help generate additional profits.
It’s easier to see the difference when you compare the denominator:
ROCE = EBIT / (Total Assets - Current Liabilities)
In this case, EBIT refers to earnings before interest and taxes. As you see, the main difference here is using total assets and current liabilities (or capital employed).
What Is a Good Return on Capital?
The higher the return, the more efficiently a company allocates its capital. It’s a good idea to compare ROC against benchmarks or standards from companies operating in similar industries or conditions. It’s also wise to look at ROC over multiple years, as this metric is rarely stable for most growth companies.
One way is to compare it with a company’s weighted average cost of capital (WACC), or the average costs to finance a company’s capital. In other words, if ROC is greater than a company’s WACC, value is being created.
A common benchmark is to check whether a company is an excess of a 2% return compared to the cost of capital. If it’s less than 2%, the company is destroying value (and there’s no extra capital to invest in growth).
Why Would Return on Capital Decrease?
If a company starts taking on projects that have decreasing returns, the ROC will decrease over time. Some reasons for this might include holding onto unused or unnecessary assets (e.g.outdated machinery) and having a large amount of liabilities (e.g. debt) which can decrease a return on capital.
Return on Capital vs. Return of Capital
They sound similar but return on capital and return of capital are very different. Return of capital refers to a company returning original investment funds back to the investor or by liquidating assets. Return on capital refers to a company’s profitability.
Is Return of Capital Taxable?
Return of capital is a non-taxable event for the investor – as long as the capital returned doesn’t exceed the initial investment. Because it’s money being returned and not earned, it’s not considered taxable income. Once returns exceed the original initial investment, it counts as a capital gain and is therefore taxable.
Return on Capital and Return on Equity
Return on equity (ROE) is a measure of profitability in relation to shareholders’ equity (ie. all ownerships’ interests). ROC measures profitability based on capital invested, including debt.
To put it another way, the return on equity measures the company profit based on the combined total of all of a company’s ownership interests. Like return on capital, ROE is typically expressed as a percentage.
Return on Equity Formula
The ROE formula considers income that may not be attributable to a company’s operations (ie. its net income). It tends to provide a more accurate picture of how efficiently money from shareholders is being handled, though it may ignore the impact of taking on debt to finance growth.
Return on Equity (ROE) = net income / average shareholder’s equity * 100