Return of Capital vs Return on Capital

The terms Return of Capital and Return on Capital differ vastly, although can be very confusion due to similar sound. The term return of capital gained significance in finance and especially the lending world (banks, NBFCs) of late, as NPAs started mounting and lenders were forced to concentrated on return of capital (principal loan amount) instead of the return on capital (interest on loans).

Below is an in-depth explanation for difference between these two financial parameters:

Return of Capital: An event where the initial capital invested by a shareholder / an investor is paid back to the shareholder is termed as Return of Capital. E.g. if 1,000 shares are purchased at a price of Rs. 100 per share, total capital invested is Rs. 1,00,000. If subsequently the share price falls to Rs. 95, value of the investment declines to Rs. 95,000. If the share price increases from here to Rs. 103 per share when the shareholder sells these shares, he gets back Rs. 1,03,000. This is termed as return of capital of Rs. 1,00,000, in addition to profit of Rs. 3,000. At Rs. 95 per share, entire capital would not be returned to the shareholder and he would suffer loss.

There is another meaning of Return of Capital too, specifically for investment in publicly traded stocks, when company returns the capital to shareholders in the form of an equity buy-back. This differs from a cash dividend, as in this case the equity of the company is decreased, whereas in case of dividends, the amount is paid out of company’s profits. Return of capital via a buy-back enables the company to reduce its outstanding share capital and in turn decreases the shareholder’s investment in the company. The tax in case of return of capital is to be paid only on the capital gain the investor has realised through the transaction. Thus, return of capital is not taxed, while only return on capital is taxable.

For example: A person has invested Rs. 100 in a financial instrument and receives Rs. 110 as a return of capital from the company after a year, then the amount is considered as a return of capital and the profit of Rs. 10 above the investment of Rs. 100 is taxed as capital gains to the investor.

Return on Capital (RoC) or Return on Capital Employed (RoCE): A profitability ratio that indicates the efficiency of a business to generate profits from the capital employed. It helps understand how many rupees of profit each rupee of capital employed is generating.

In the above example, Rs. 100 is the return of capital while Rs. 10 is the return on capital.

This ratio is useful for comparing how effectively companies are using the capital on hand. The formula for calculating ROC/ROCE is:

ROCE = Earnings Before Interest and Tax / Capital Employed

Interest expense is included in the numerator as debt on which interest is paid is part of the denominator.

Capital Employed = Total Assets – Current Liabilities or

                             = Shareholder’s Funds + Long term Borrowings              

Consider real life financial examples of two listed companies Yuken India and Shakti Pumps for FY 2018, to understand RoCE better:

Thus, the Return on Capital or Return on Capital Employed helps us understand that for every rupee invested in Yuken India, an investor had a return of Rs. 0.2381 and similarly every rupee invested in Shakti Pumps had a return of Rs. 0.2101. This makes the investor aware of which business is providing a better return on the capital employed by them in the business activity. In the above case, Yuken India seems to provide a slightly better return than Shakti Pumps.