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What is Return on Capital?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 14 September 2016
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A return on capital is a means of measuring how well a given company invests funds in its basic business operation. While there are various formulas used to determine this particular relationship between those invested funds and the returns generated as the result of those funds, many companies find that identifying the return on capital is very important to determining the financial strength of the business, and finding ways to aid the company in achieving additional growth over time. Typically, the means of determining a return on capital will focus on the pretax income that is generated in comparison to the amount of the funds that the company invests in the business.

One common approach to determining a return on capital involves identifying the amount of net income that is generated during a given period of time, after excluding any amount of after-tax interest expense that may have occurred during that period. The resulting figure is divided by the average capital relevant to the period. The amount of that return on capital can then be used as part of the assessment of the overall business operation, and may form the basis for making changes if the return is not considered sufficient for the amount of funds invested in the operation.

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A return on capital that decreases with each successive time period may be a sign that the company needs to look closely at operational expenses and other expenditures and make some changes in how the business operates. The changes may involve strengthening the sales and marketing effort as a means of attracting more customers and boosting sales. At the same time, a low return on capital may trigger an investigation into the operational structure that results in changing policies and procedures so that the business lowers costs and generally operates more efficiently. This in turn can have a positive impact on net profits and cause the downward trend in the capital returns to cease and allow the fortunes of the business to begin increasing once more.

There is no one reason why a return on capital would be less than anticipated. At times, the original projections of the return may have been more hopeful than factual. Even if those projections were realistic, the lower returns may be due to some event or series of events that was not foreseen when the capital was originally invested in the operation. For this reason, taking the time to determine what led to the return on capital is important, both from the perspective of capitalizing on those positive factors in the future and minimizing the impact of any negative factors in subsequent periods.

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