Let’s look at Return on Capital (different to Return on Equity, ROE) and ask how does it work for analysing strong healthy companies?
Return on capital is the same formula as return on equity ROE, but in addition of the value of ownership interests in a company (equity), also includes the total value of debts owed by the company in the form of loans and bonds.
The Formula is:
ROC = Net Income (profit/earnings) EBIT
( Shareholders’ Equity + Total Liabilities)
How It Works/Example:
Let’s assume Company ABC generated
- $5,000,000 in net income last year
- shareholders’ equity equalled $20,000,000 last year, and
- total liabilities were $10,000,000,
then we can calculate ROC as:
ROC = $5,000,000/($20,000,000+10,000,000) = 0.17 or 17%
This means that Company ABC generated $0.17 of profit for every $1 of shareholders’ equity
Why It Matters:
ROC is a measure of profit as well as a measure of “efficiency” which takes into account debt/borrowings.
If there is NO debt, the result will be the same as return on equity (ROE), however, when there is debt, the denominator figure is larger, resulting in a lower ratio figure than the ROE.
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