Companies need money to operate and grow their businesses in order to generate returns for their investors. Investors put money--called capital--into a company, and then it is the company's responsibility to create additional money--called profits--for investors. The ratio of the profit to the capital is called the return on capital. It is important to remember that the absolute level of profits in dollar terms is less important than profit as a percentage of the capital invested.
For example, a company may make $1 billion in profits for a given year, but it may have taken $20 billion worth of capital to do so, creating a meager 5% return on capital. This particular company is not very profitable. Another firm may generate just $100 million in profits but only need $500 million to do so, boasting a 20% return on capital. This company is highly profitable. A return on capital of 20% means that for every $1.00 that investors put into the company, the company earns $0.20 per year.
The Two Types of Capital >>