Advertisement

Return on capital

Return on capital is one of the most useful ratios when it comes to measuring the performance of a company.

Return on capital is one of the most useful ratios when it comes to measuring the performance of a company. The basic sum is simple: you just express a firm's net profit as a percentage of the capital the company has used - both shareholders equity (the net assets of the company that belong to the shareholders - the balance of assets and liabilities) and debt (long term and short term).

Advertisement - Article continues below

For the firm to be adding value, the return on capital should be greater than the cost of capital and, all things being equal, a firm making high return on capital should be considered superior to one making a lower return.

In most cases, however, all things are not equal. You would, for example, expect service companies, such as an advertising or design agency, to have higher returns on capital (as they have little in the way of physical assets and much in the way of intellectual capital, which is not accounted for in this calculation) than very capital-intensive companies, such as car manufacturers. This means that care must be taken when comparing the return on capital of different firms.

If a firm generates operating profits (also known as earnings before interest and tax, or EBIT) of £80m and carries debt of £400m plus shareholders' funds of £400m, then return on capital employed is 80/800 x 100%, or 10%. This is the return to both lenders and shareholders the higher, the better. It may be compared to the return available from other investments.

A common variant is return on equity, or ROE. This uses operating profit after interest charges as a percentage of just shareholders' funds. So if interest charges were £20m, then ROE would be (80-20)/400 x 100%, or 15%. This is the return the firm makes for its shareholders only.

Advertisement
Advertisement

Recommended

Visit/glossary/601570/real-exchange-rate
Glossary

Real exchange rate

The real exchange rate between two currencies combines the nominal exchange rate with the ratio of the price of goods or services in two different cou…
26 Jun 2020
Visit/glossary/esg-investing
Glossary

ESG investing

ESG stands for environmental, social and corporate governance, the areas in which good behaviour is particularly sought.
19 Jun 2020
Visit/glossary/601496/faang-stocks
Glossary

FAANG stocks

The acronym FAANG refers to Facebook, Amazon, Apple, Netflix and Google (Alphabet) – five American companies that have been among the top-performing s…
12 Jun 2020
Visit/glossary/technical-analysis
Glossary

Technical analysis

Technical analysts or 'chartists' attempt to predict future share price (or index) movements by looking at past movements.
5 Jun 2020

Most Popular

Visit/investments/property/601606/house-prices-crash-uk-property-prices-falling-where-next
Property

House price crash: UK property prices are falling – so where next?

With UK property prices falling for the first time in eight years, are we about to see a house price crash? John Stepek looks at what’s behind the sli…
2 Jul 2020
Visit/economy/inflation/601584/the-end-of-the-bond-bull-market-and-the-return-of-inflation
Inflation

The end of the bond bull market and the return of inflation

Central bank stimulus, surging post-lockdown demand and the end of the 40-year bond bull market. It all points to inflation, says John Stepek. Here’s …
30 Jun 2020
Visit/investments/stockmarkets/601611/nasdaq-all-time-high-markets-and-the-real-economy
Stockmarkets

How can markets hit new record highs when the economy is in such a mess?

Despite the world being in the midst of a global pandemic, America's Nasdaq stock index just hit an all-time high. And it's not the only index on a bu…
3 Jul 2020