Return on capital | Finance & Capital Markets | Khan Academy
How to Calculate Return on Capital
Return on invested capital (ROIC) is one of the most important ratios to consider when you're thinking about investing in a company. It's a ratio that measures how much money a business is able to generate on the capital employed. It's typically reported in the "Fundamentals" section of your favorite online stock screener. However, you can also calculate it from the company's financial statements.
Sample return on capital calculator
Calculating Return on Capital
Gather the company's financial statements.The formula for calculating return on invested capital is ROIC = (Net Income - Dividends) / Total Capital. As you can see you're going to need three pieces of information, each of which comes from a different financial statement.
- The net income is found on the company's income statement.
- The dividend payout is obtained from the company's cash flow statement.
- The total capital is calculated from the company's balance sheet.
Get the net income for the year from the income statement.This is typically located on the bottom line. The income statement shown is taken from a prominent public company. It shows that the company's net income for the year ending Dec 31, 2009 was ,025,000,000. (Note that all numbers in the statement are in thousands.)
Subtract any dividends the company may have issued.Companies don't need to issue dividends, but many of them do. The dividend distribution amount is found on the company's cash flow statement, in the section titled "Cash From (Used By) Financing Activities" (or words to that effect).
Subtract dividends from net income, and divide by the total capital.This gives you the return on capital. In this example, the return on capital is ,025,000,000/4,732,000,000 = 0.025, or 2.5%. This means that the company generated a return of 2.5% on its available capital in the year 2009. The total return on capital takes into account the dividends and the net income transferred to retained earnings.
Making Sense of ROIC
Determine the management effectiveness of the company.ROIC is a measure of how effective a company is at turning investor capital into profit. A company that can consistently generate ROICs of 10% to 15% is great at returning invested money to its stock- and bond-holders.When looking at companies to invest in, this ratio can be very helpful.
- Look for high ROICs. The higher the ROIC, the better the company is at taking money and turning it into profit.
Use ROIC to separate the bad stocks from the good stocks.Let's say a company with 0,000 net income takes on million in debt. The company then proceeds to earn million in net income, thereby increasing their net income by 100%. If you looked only at earnings growth, you wouldn't notice that it took the company million to create that million growth. Their ROC of 10% isn't very impressive.
- This may be a helpful analogy: Think about basketball players. You might think that a player who averages 15 points on 20 shots per game has a great game if he scores 30 points. But if you notice that he took 60 shots to get those 30 points, you might not think he had such a great game after all, because he was actually less efficient than usual in his shooting.
- ROIC works the same way. In the basketball analogy, ROIC would be telling you how efficient a player is at scoring.
Use ROIC instead of other ratios.Return on capital is a better measure of investment return than are either return on equity (ROE) or return on assets (ROA). That's because those other ratios are based on incomplete or possibly inaccurate data.
- Regarding ROE, if you put in 00 to start a business, borrow ,000, and make 0 after one year, your ROE is a generous 0/00, or 50% per year. This seems too good to be true. Well, it is. The actual return on invested capital is 0/(00+,000) = 4.55%, a more reasonable figure.
- ROA is unreliable. That's because of the difference between an asset's cost and its market value at any given moment in time.
QuestionReturn on capital: 20% over 4 years. Does this mean 20% each year over a 4-year period, or 20% in total over 4 years?Top AnswererIt means the latter. To mean the former, you'd say, "average annual return of 20%."Thanks!
QuestionWhat does a negative percentage mean?Top AnswererIt would mean the company in question had paid out more in dividends than it generated in net income for the year. That would never actually happen.Thanks!
How do I find return on capital?
How do I calculate the return on capital if the company pays back some of an investment during the year, as well as paying a dividend?
- The higher the return on capital, the better. The most important thing to look for isconsistency.If a company can consistently make 15% or more return on capital for at least ten years, that is very likely an excellent company, but past performance doesn't always guarantee future results.. Also compare a company's return on capital with that of its competitors when deciding whether to invest.
Sources and Citations
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Video: Ratio Analysis: Return on Capital Employed (ROCE)
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