What is Returns on Capital Employed – Calculation and Formula with Examples
Every organisation operates with the help of several factors of production like land, labour and capital. All these allow firms to create value that they sell and earn profits. In this regard, capital or capital employed is the total investment that a company makes for running the operations.
Capital employed may also denote the total value of assets that a company owns for running the business. It is a useful financial metric that companies use to compute the return on capital employed, which is a measure of how efficiently they are using their capital.
Read on to learn more about capital employed, its importance and how to calculate it.
What is Capital Employed?
Capital employed is defined as an indicator that determines the total amount of funds put into a business by the owners and investors or the funds used by firms for business expansion activities. The capital employed in a business forms the cornerstone of earning profits.
In case businesses source a major chunk of their capital employed from non-shareholders, it indicates a high proportion of debt in the capital. As you know, debts are always risky; therefore, it makes new investors apprehensive about putting in their money. However, it may also imply high expansion or aggressive plans, which can lead to high returns in future.
Now that you are aware of the meaning of capital employed, let’s move on to its other aspects.
What is the Importance of Capital Employed?
Capital employed helps businesses by denoting the efficiency or productivity of their capital. One can review their financial position by looking at the capital employed and make necessary adjustments to make their firm more competitive.
The capital employed formula is:
Capital Employed = Total Assets – Value of Current Liabilities
You can combine capital employed with various other financial metrics and calculate the return on capital employed, which gives an idea about approximate returns that the company may make with the corresponding capital.
What is Return on Capital Employed?
ROCE, or returns on capital employed, is a financial ratio used for measuring the profitability of capital invested by a company. It is an important indicator that prospective investors and stakeholders assess before investing in a company.
A higher ROCE means the company is highly profitable, and a lower ROCE implies low profitability. Stakeholders can look at this ratio and get an idea about the gains or profits that the company makes per rupee of capital employed. It is also known as a company’s primary ratio.
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What is Considered as a Good Return on Capital Employed Value?
As a general principle, a higher return value indicates a more efficient and profitable company. A ratio percentage of more than 20% is considered a good ROCE number. This indicates a robust financial position of the company.
At the same time, a lower value of ROCE is not necessarily bad for the company. This is because sometimes, a lower value may be attributed to the high cash-in-hand position of the company. Therefore, high cash-in-hand may pull the ROCE value down, even though the company has a robust financial situation.
How to Calculate ROCE?
The formula for return on capital employed is as follows:
ROCE = EBIT/ (Capital Employed);
Where capital employed is total assets – current liabilities, and EBIT is earnings before interest and tax.
With the help of ROCE, you can compare the profitability levels of companies from the same sector with regard to the capital investment made. One must know the earnings before interest and tax as well as the capital invested for calculating the value.
EBIT is operating gains acquired by a company before deducting interest payments and tax. In order to calculate this value, you must subtract the cost of raw materials and operating expenses from total revenue.
On the other hand, capital employed is the amount of money invested in the business. Many companies also use average capital employed instead of capital employed to compute ROCE. The average capital employed is the average closing and opening balance of capital for a particular time period.
Now that you are aware of the ROCE formula, let’s understand the working of return on capital employed with the help of an example.
Let’s understand this with an example.
The hypothetical comparison of ROCE between two companies, i.e., ABC Enterprises and XYZ Pvt Ltd, is as follows:
| Parameter | ABC Enterprises | XYZ Pvt Ltd |
| Sales | Rs. 10,000 | Rs. 15,000 |
| EBIT | Rs. 4,000 | Rs. 5,000 |
| Total Assets | Rs. 26,000 | Rs. 54,000 |
| Current Liabilities | Rs. 11,000 | Rs. 17,000 |
| Capital Employed | Rs. 15,000 | Rs. 37,000 |
| Return on Capital Employed | 0.27 | 0.16 |
From the above example, we can see that the return on capital employed ratio of ABC Enterprises is higher than XYZ Pvt Ltd, even though the latter has higher revenues and EBIT. Therefore, we can conclude that ABC Enterprises is more efficient in capital management or productivity of capital.
What is the Formula to Calculate Capital Employed?
You can calculate capital employed with the help of two formulas:
1. Capital Employed = Total Assets – Current Liabilities
In this formula, the total assets include fixed assets after taking into account their depreciation. It will also include cash at hand, cash at bank, bills receivables, other current assets and any investments made into the business.
2. Capital Employed = Non-Current Assets + Working Capital
Working capital is the difference between current assets and current liabilities. Non-current assets are those investments whose value you cannot fully realise in a current financial year. This includes all tangible and intangible assets like brand value, goodwill and intellectual property rights.
Return on Capital Employed vs. Return on Equity
Here are some differences between ROCE and ROE:
| Parameter | ROCE (Return on Capital Employed) | ROE (Return on Equity) |
| Definition | It is a percentage value that tells us the level of efficiency or productivity of invested capital. | It is a percentage of the company’s income returned to equity shareholders. |
| Formula | ROCE = EBIT/Capital Employed, where EBIT is earnings before interest and tax. | ROE = Net Income/Shareholders Equity. |
| Use | It is a useful metric for comparing the performance of various capital-intensive companies in the same sector. | Stakeholders and investors use this to make investment plans. |
| Implications | A higher ROCE value indicates higher profitability levels and vice versa. | A higher return on equity value indicates that the company is using shareholders’ money efficiently and the financial outlook is stable. |
How to Use ROCE in Investment?
Return on capital employed plays an important role in the future investment prospects of a company. A higher ROCE value indicates that an organisation or a company is using their corporate resources effectively to generate maximum profits. In other words, it implies sound financial health and outlook for the company.
Therefore, a favourable ROCE value tends to attract investors from different arenas and boost the company’s growth prospects. The confidence of investors can increase in the company’s management once they believe that the managers can optimally utilise the invested money and provide significant returns.
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Final Word
Capital employed is the total money that the owners, investors and shareholders of a company put into the organisation for acquiring assets and generating profits. You can calculate the capital employed by using the value of total assets and the total liabilities of a company; both of these values can be found on a company’s balance sheet.
Investors primarily use this metric to assess a company’s profitability before going ahead with an investment.
FAQs
Ans. It may not be an ideal tool for comparing the performance of companies across different sectors. Moreover, firms having huge amounts of unused cash balances or cash-in-hand may have lower ROCE. However, it may not necessarily mean anything regarding the profitability of the company.
Ans. Yes, retained earnings are a component of non-current liability, as companies are not liable for settling them within the same financial year. Therefore, retained earnings are a part of capital employed.
Ans. Goodwill is an intangible asset as well as a capital asset. It is reputation or brand value in the eyes of customers which acts as an asset. Therefore, it does form a part of capital employed.
Ans. The cost of capital is the rate of return a company expects to generate from its investment in order to compensate the investors for their contribution of capital. In other words. It is the return a company needs to generate in order to justify its value in the market.
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