MASTERCLASS Investing – What is Return on Capital – what does it mean and how to calculate rate of return?

Investing – What is Return on Capital – what does it mean and how to calculate rate of return?

Return on Capital  is similar to Return on Equity, ROE which we covered before, but also includes capital costs. So what is Return on Capital and how to calculate this rate of return.

Return on Capital is the same formula as Return On Equity ROE, but in addition to the value of ownership in a company (equity), we include the capital employed such as 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

1.     \$5,000,000 in net income last year,

2.     Shareholders’ equity equalled \$20,000,000 last year, and

3.     Total debt/liability \$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 capital.

Why It Matters:

ROC is a measure of profit against capital 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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