How do you calculate profit on capital?
Profit is the financial return that a company earns from its activities. But it is also important to consider what was invested in order to earn this return. One way to analyze return on investment is to calculate return on capital. Capital is the amount invested in the project and return on capital is the percentage return on that investment.
The method of calculating the percentage of profit from the capital is:
(net profit before tax ÷ invested capital) 100X = return on capital
What does the return on capital tell us?
* A measure of the returns achieved from the investment in the project.
* How well the business converts the invested money into profit.
* Provides a way to compare with other investment opportunities
* Opportunity cost, which is what the investor would have done if he had chosen to invest elsewhere.
Evaluating the company’s financial performance includes analyzing the return on capital, that is, the percentage of profit from capital. The figure below shows Company A’s earnings performance for the year before interest and income tax. Did the company make enough operating profit compared to the capital it used to make that profit?
Suppose Company A used $100,000,000 in capital to earn its operating profit of $1,800,000. In this case, the company generated a measly rate of return of 1.8 percent on invested capital:
$100,000,000 operating profit ÷ $100,000,000 capital = 1.8 percent rate of return $1,800,000
1.8% is a meager return on capital performance by all standards.
Operating liabilities typically represent 20 percent or more of a company’s total assets. What remains is the amount of capital that the company has to raise from two primary sources: borrowing money on the basis of interest-bearing debt instruments, and raising capital (equity) from private or public sources.
Sources of capital for company “A”
* Debt $4,000,000
* Equity is $8,000,000
* The total capital is $12,000,000
Suppose the following:
The return on the capital of Company A for the year is:
$1,800,000 operating margin ÷ $12,000,000 equity = 15.0 percent return on equity
Company A’s annual interest expense on its debt is $240,000. Deducting interest from operating profit of $1,800,000 gives a profit of $1,560,000 before income tax. So the rate of return on equity (before income tax) of a company is calculated as follows:
$1,560,000 profit before income tax ÷ $8,000,000 equity = 19.5 percent return on equity
Debt provides 1/3 of the company’s capital (4,000,000 ÷ 12,000,000 total capital = 1/3). The company made a 15 percent return on its debt principal ($4,000,000 in debt x 15% rate of return = $600,000 return on borrowed equity). Since interest is an amount fixed by contract for each period, the company only had to pay $240,000 in interest for using the borrowed capital.
The excess of earned operating profit refers to the borrowed capital over the amount of interest and leverage gains. Company A had a financial profit of $360,000 for the year ($600,000 operating profit earned on borrower capital – $240,000 interest paid on debt = $360,000 financial gain).