Resolved: Return on capital ratio
I am wondering why in the return on capital we use EBIT not net income?
Aslo i think return on capital must equal return on assets
Hi Mohamed,
this is a valid question, here is the logic.
Return on capital uses EBIT rather than net income because the goal of the metric is to measure the efficiency of the company’s operations independently of its financing choices. EBIT represents operating profit before the effects of interest and taxes. This matters because return on capital is intended to show how effectively the company’s invested capital—both debt and equity—is being used to generate operating earnings. If net income were used instead, the result would be affected by the firm’s capital structure, interest expenses, tax strategies, and non-operating gains or losses. Two companies with identical operating performance could appear to have different returns simply because one carries more debt or operates in a different tax jurisdiction.
Using EBIT allows us to isolate and evaluate the core operations of the business. It also ensures that the return we measure is consistent with the capital base we compare it to. Invested capital includes both debt and equity, which means it is an unlevered measure, and therefore it should be matched with an unlevered measure of return. Net income, by contrast, is a levered measure that reflects returns to equity holders only, after financing costs.
I hope this makes sense.
On the second question - it’s a common intuition to think that return on capital and return on assets should be the same, because both are meant to measure how efficiently a company uses what it has. But they are actually different concepts, and in practice they usually do not produce the same number.
Return on assets measures how much net income the company generates relative to all assets on the balance sheet. This includes operating assets as well as non-operating or idle assets, and it uses a levered profit measure, since net income is after interest and taxes. Return on capital, on the other hand, focuses specifically on the assets that are actually used in the operations of the business—typically operating assets minus non-interest-bearing current liabilities—and it uses an unlevered profit measure such as EBIT or NOPAT. Because the definitions of both the numerator and the denominator differ, the ratios capture different things.
Return on assets tends to be lower because the denominator includes every asset on the balance sheet, even those not directly tied to core operations, and the numerator is reduced by financing costs. Return on capital tends to be higher because it isolates only the capital invested in the operations of the business and matches it with an operating return that excludes interest and tax effects. In short, ROA measures profitability relative to total assets, while return on capital measures operating efficiency relative to the capital employed. They are related but not equivalent, and it’s normal for them to differ.
Best,
Antoniya
