Think of companies as machines with two spouts. Investors shovel their moneycalled capitalinto one spout, and the job of the company is to spit moneycalled profitsout from the other. The ratio of the profit to the capital is called return on capital. The absolute level of profits in dollar terms isnt nearly so important as profit as a percentage of the capital is.
Take an example. A company may have $1 billion in profits in a given year, but its return on capital might be a meager 4%. It is therefore not a very profitable company. Another firm might generate just $100 million in profits but sport a return on capital of 30%. Now theres a profitable company. A return on capital of 30% means that for every $1.00 investors have put into the company, the company earns $0.30 in profits.
The Two Types of Capital >>