What Is an Economic Spread?
- An economic spread is a performance metric used by companies to determine the difference between a company's weighted average cost of capital and its return on invested capital.
- Companies calculate economic spreads to determine how well they are using their capital.
- Calculations of economic spreads and the real rate of return must also take inflation into account.
- A company with a high economic spread is a sign of efficiency and good overall performance.
- A negative economic spread suggests a company is over-leveraged or not using its capital appropriately.
Understanding Economic Spreads
Simply put, an economic spread is a measure of a company's ability to make money on its capital investments. If the cost of capital exceeds the return on invested capital, the company is losing money; what the capital is doing with its assets is not providing enough to cover the cost of borrowing or using it. This could be down to inefficiencies or merely a poor investment.
A company with a high economic spread is a sign of efficiency and good overall performance. On the contrary, a company can have a negative economic spread, which can be a sign of stress on its assets and can often mean the assets are outdated or the company is over-leveraged.
Some financial pundits refer to economic spread as market value added because the spread is a representation of a company's value from an operations standpoint.
The term is important for evaluating the returns of a pension plan. The value of its invested funds may be increasing at what seems to be an acceptable level, but if the invested capital is not growing at a rate above inflation, the investment is losing its value on an annual basis.
This nominal loss results from the fact that the invested capital will not be able to buy as much for the investor in the future as it can at the present time.