Return on assets and return on capital provide measures of how well a company is using its available resources to generate profit. Comparing profitability ratios such as these with the ratios put up by other companies in your industry can help you determine whether you're making as much profit as you can, and tracking your own ratios over time can tell you whether you're becoming more efficient.
Return on assets measures how efficiently your business uses its assets to generate profit. The ROA formula is net income divided by average assets. Net income is your profit for a given period, such as a quarter or year. The simplest way to compute average assets is to add together the total value of your company's assets on the balance sheet at the beginning of the period and the total value of your assets at the end of the period and divide by two. ROA tells you how much profit you made for each dollar's worth of assets. If you had net income of $10,000 and average assets of $50,000, ROA would be 0.2 -- 20 percent, or 20 cents of profit per dollar of assets.
Return on assets is about percentages, not raw figures. A $50,000 profit looks better than $20,000 on paper, but if the company has $2.5 million in assets, it's a paltry 2 percent ROA. On the other hand, if the company with a $20,000 profit had only $150,000 in assets, it has an ROA above 13 percent. With return on assets, what makes for a good or bad figure depends largely on your industry. The more capital-intensive the industry, the lower the ROA benchmark, because you need a large amount of assets just to be in business. Skill- or knowledge-based industries tend to have a higher ROA because they make money with assets that don't appear on the balance sheet -- people, for instance.
While return on assets has a standardized formula, return on capital does not. The ROC formula varies from one source to the next, but all the variations aim to tell you the same thing: how efficiently the company is using the money invested in it to generate profit from day-to-day operations. A common ROC formula is net operating profit after tax divided by invested capital. To calculate it, take your operating income -- revenue minus operating expenses -- and multiply by 1-t, with "t" being the effective tax rate you pay on company profits, either as corporate income taxes or as personal income taxes on business profit. Invested capital is the book value of the owners' equity in the company, plus the book value of the company's debt, minus the company's cash balance.
By using net operating profit after tax rather than net income, the ROC formula focuses only on profit generated by the regular conduct of the business. It leaves out gains or losses from non-operating items, such as asset sales, and interest on borrowing, none of which are included in operating income. The formula then compares this profit to invested capital, or the total amount of money that's currently in the business. That can be either the owners' money or borrowed money. Invested capital does not include cash because cash is not money invested in the business -- for example, in the form of buildings and equipment, inventory or some other asset. Even if it's in the bank earning interest, cash is not capable of generating any operating profit.