Return on Capital Employed Ratio (ROCE Ratio):
The prime objective of making investments in any business is to obtain
satisfactory return on capital invested. Hence, the return on capital employed
is used as a measure of success of a business in realizing this objective.
Return on capital employed establishes the relationship between the profit and
the capital employed. It indicates the percentage of return on capital employed in the business and it can be used to show the
overall profitability and efficiency of the business.
Definition of Capital Employed:
Capital employed and operating profits are the main items. Capital employed
may be defined in a number of ways. However, two widely accepted definitions are
"gross capital employed" and "net capital employed". Gross capital employed
usually means the total assets, fixed as well as current, used in business,
while net capital employed refers to total assets minus liabilities. On the
other hand, it refers to total of capital, capital reserves, revenue reserves
(including profit and loss account balance), debentures and long term loans.
Calculation of Capital Employed:
Method--1. If it is calculated from the assets side, It can be worked
out by adding the following:
- The fixed assets should be included at
their net values, either at original cost or at replacement cost after deducting
depreciation. In days of inflation, it is better to include fixed assets at
replacement cost which is the current market value of the assets.
- Investments inside the business
- All current assets such as cash in hand, cash at bank, sundry debtors, bills
receivable, stock, etc.
- To find out net capital employed, current liabilities are deducted from the
total of the assets as calculated above.
Gross capital employed = Fixed
assets + Investments + Current assets
Net capital
employed = Fixed assets + Investments + Working capital*.
*Working
capital = current assets − current liabilities.
Precautions For Calculating Capital Employed:
While capital employed is calculated from the asset side, the following
precautions should be taken:
- Regarding the valuation of fixed assets, nowadays it is considered necessary
to value the assets at their replacement cost. This is with a view to providing
for the continuing problem of inflations during the current years. Under
replacement cost methods the fixed assets are to be revalued on the basis of
their current market prices either by reference to reliable published index
numbers, or on valuation of experts. When replacement cost method is used, the
provision for depreciation should be recalculated since depreciation charged
might have been calculated on original cost of assets.
- Idle assets―assets which cannot be used in the business should be
excluded from capital employed. However, standby plant and machinery essential
to the normal running of the business should be included.
- Intangible assets, like goodwill, patents, trade marks, rights, etc.
should be excluded. However, if they have sale value or if they have been
purchased they may be included.
Investments made outside the business should be excluded.
- All current assets should be properly valued. Any excess balance of cash
or bank than required for the smooth running of the business should be
excluded.
- Fictitious assets, like preliminary expenses, accumulated losses, discount
on issue of shares or debentures, advertisement, suspense account, etc. should be
excluded.
- Obsolete assets which cannot be used in the business or obsolete stock
which cannot be sold should be excluded.
Method--2. Alternatively, capital employed can be calculated from the
liabilities side of a balance sheet. If it is calculated from the liabilities
side, it will include the following items:
Share capital:
Issued share capital (Equity + Preference)
Reserves and Surplus:
General reserve
Capital reserve
Profit and Loss account
Debentures
Other long term loans Some people suggest that average capital employed
should be used in order to give effect of the capital investment throughout
the year. It is argued that the profit earned remain in the business
throughout the year and are distributed by way of dividends only at the end
of the year. Average capital may be calculated by dividing the opening and
closing capital employed by two. It can also be worked out by deducting half
of the profit from capital employed.
Computation of profit for return
on capital employed:
The profits for the purpose of calculating return on capital employed
should be computed according to the concept of "capital employed used".
The profits taken must be the profits earned on the capital employed in the
business. Thus, net profit has to be adjusted for the following:
- Net profit should be taken before the payment of tax or provision for
taxation because tax is paid after the profits have been earned and has no
relation to the earning capacity of the business.
- If the capital employed is gross capital employed then net profit should
be considered before payment of interest on long-term as well as short-term
borrowings.
- If the capital employed is used in the sense of net capital employed
than only interest on long term borrowings should be added back to the net
profits and not interest on short term borrowings as current liabilities are
deducted while calculating net capital employed.
- If any asset has been excluded while computing capital employed, any
income arising from these assets should also be excluded while calculating
net profits. For example, interest on investments outside business should be
excluded.
- Net profits should be adjusted for any abnormal, non recurring, non
operating gains or losses such as profits and losses on sales of fixed
assets.
- Net profits should be adjusted for depreciation based on replacement
cost, if assets have been added at replacement cost.
Formula of return on capital employed
ratio:
Return on Capital
Employed=(Adjusted net profits*/Capital
employed)×100
*Net
profit before interest and tax minus income from investments.
Significance of Return on Capital
Employed Ratio:
Return on capital employed ratio is considered to be the best measure of
profitability in order to assess the overall performance of the business. It
indicates how well the management has used the investment made by owners and
creditors into the business. It is commonly used as a basis for various
managerial decisions. As the primary objective of business is to earn profit,
higher the return on capital employed, the more efficient the firm is in using
its funds. The ratio can be found for a number of years so as to find a trend as
to whether the profitability of the company is improving or otherwise. |
