What Is Return on Total Capital

Stock Pitches Return on total capital is a measure of a company’s efficiency in turning assets into profits. It includes both shareholders’ equity and debt financing in the denominator, but excludes returned profits (NOPAT), which is a tax-affected version of EBIT.

Companies can use any amount of capital to fund their operations, and there are two common sources: debt and equity. Companies that generate returns of two percent or higher above their weighted average cost of capital are considered value creators.

Assets

Using this metric, investors can compare a company to its peers in the same industry and determine whether the firm is using its assets well. This ratio is especially useful when evaluating companies that use large amounts of capital such as construction or equipment firms, as well as software and technology businesses.

The calculation for ROIC requires a number of items, including the current assets and fixed assets on the balance sheet as well as the stockholders’ equity and debt on the statement of financial position. It is important to note that both the numerator and denominator of this ratio can be skewed by a few things. For example, adding back in interest expense into the numerator can make this metric misleading.

Likewise, a high amount of capital leasing may skew the results as well as any excess cash on hand. Therefore, it is important to perform the calculations correctly so you can get an accurate picture of a company’s profitability.

Liabilities

Liabilities are the financial obligations that a company has that need to be paid in the future. These include everything from a credit line to debt taken on to finance operations or pay for expansions. Unlike expenses that are reported on the income statement, liabilities appear in the balance sheet.

There are several categories of liabilities: current, long-term and other. Current liabilities are due to be paid within a year and are comprised of the money owed to lenders, accounts payable and salaries. Long-term liabilities are those that take longer than a year to be paid and are typically represented by bonds, mortgages, pension liabilities, accrued interest, deferred taxes and other non-current liabilities.

A high level of liabilities can be a concern if it means that the company won’t have enough income to fulfill its obligations. But a growing amount of liabilities can also be a sign of growth for the business that will benefit it in the long run.

Shareholders’ Equity

The shareholders’ equity of the company is the value that shareholders have invested in a business. This value reflects the profits earned by the company and how it chooses to either pay out dividends or reinvest the profits back into the business for growth. Shareholder’s equity can be calculated from the total assets of a company less total liabilities.

A company’s total assets are made up of current assets, which are highly liquid and include items like inventory and accounts receivable and non-current assets, which are long term investments in things like property, plant and equipment and investments. The company’s total liabilities are the sum of its current debts and long term debts.

The company’s total shareholder’s equity is the difference between its total assets and its total liabilities. This value can be found on the balance sheet under the section labeled shareholder’s equity. The components that go into this value are common stock, preferred shares and retained earnings.

Net Income

A company’s net income plays an important role in determining its growth strategies. For example, a strong net income might inspire the business to expand its operations or hire additional employees. Conversely, a weak net income might necessitate cost-saving measures. Lenders and investors also closely scrutinize a company’s net income before extending loans or making investments.

ROIC is a ratio that measures the profitability and value-creating potential of companies relative to the capital invested by shareholders and debtholders. It is calculated by dividing net operating profit after tax (NOPAT) by invested capital.

NOPAT is defined as recurring operating profits minus interest and taxes. It is a more accurate measure of a company’s performance than gross profit, which excludes non-operating items such as reversals of accrued expenses and unrealized gains on equity investments. It is also more meaningful than net income attributable to common shareholders, which includes one-time events such as preferred dividend issuance or stock buybacks.