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 (ROCE) 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:

Method1. If it is calculated from the assets side, It can be worked out by adding the following:

1. 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.
2. Investments inside the business
3. All current assets such as cash in hand, cash at bank, sundry debtors, bills receivable, stock, etc.
4. 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:

1. 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.
2. 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.
3. 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.

4. 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.
5. Fictitious assets, like preliminary expenses, accumulated losses, discount on issue of shares or debentures, advertisement, suspense account, etc. should be excluded.
6. Obsolete assets which cannot be used in the business or obsolete stock which cannot be sold should be excluded.

Method2. 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 (ROCE ratio):

Return on capital employed ratio (ROCE 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.

You may also be interested in other articles from financial statement analysis chapter: