| How to Calculate Return on Capital Dec 18th 2012, 20:00 Return on capital (ROC), or return on investment (ROI), is one the most important ratios to measure profitability of a company. It measures how much money a business or investment is able to generate on the capital employed. Despite its importance, this ratio is seldom reported and often needs to be calculated. Here is how to determine this ratio from the balance sheet and income statement. Sample return on capital calculator
Calculating return on capital - Find out the net earnings in a given year from the income statement. This is typically located at the bottom line. The income statement shown is taken from a prominent company. It shows that the company's net income for the year ending Dec 31, 2009 was $11,025,000,000. (Note that all numbers in the statement are in thousands.)
- Determine the total capital at the beginning of the given year from the balance sheet. Add up debt and total shareholder equity (which includes preferred stocks, common stocks, and capital surplus and retained earnings).
- The balance sheet for the company at the beginning of the 2009 is shown in the middle column (see image below). Using the figures from the balance sheet at Dec 31, 2008, total capital is $330,067,000,000 (long term debt) + $104,665,000,000 (total shareholder equity) = $434,732,000,000. (Again, note that all numbers in the balance sheet shown are in thousands. Also note that only long term debt is included, as short term debt by definition is due within one year, so that the company does not have use to the money for the entire year in which earnings are made.)
- Divide net earnings by total capital, which is the return on capital. For the example company, the return on capital is $11,025,000,000/$434,732,000,000 = 0.025, or 2.5%. This means that the company generated a return of 2.5% on its available capital in the year 2009.
- Return on capital is a better measure of investment return than return on equity (ROE) or return on assets (ROA). Equity does not account for all the capital a company uses to finance its operations, thus return on equity may seem artificially high for a highly leveraged company using a lot of debt. For example, if you put in $1000 to start a business, borrow $10000, and make $500 after one year, your return on equity is a generous $500/$1000, or 50% per annum. This seems too good to be true. Well, it is. The actual return on invested capital is $500/($1000+$10000) = 4.55%, a more reasonable figure. Return on assets, on the other hand, is unreliable, as the figures for plants and properties are a rough estimate at best (since there is generally no ready market for them), and goodwill and intangibles on the asset account are generally given arbitrary figures.
- The higher the return on capital, the better. The most important thing to look for is consistency. If a company can consistently make 15% or more return on capital over the past 10 years, that is an excellent company. Also compare return on capital with the company's competitors.
Edit Things You'll Need - Access to company's income statement and balance sheet (widely available on the web, or you can request from the company)
- Paper and pencil (or pen)
- Calculator (optional)
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