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“There in this business topic video. We re going to take a quick look at at one of the most important financial ratios that are used to assess the financial of the business. It s called the return on capital employed. Now of course don t forget that in business.
The main return from business activities is profit profit being the difference between total revenues and total costs. But in order to earn a profit. Most businesses have to invest invest in the business. Invest for example in inventories stocks warehouses and maybe production facilities and capacity.
If they re involved in manufacturing of course. Other businesses may be not involved in manufacturing also or still need to invest in distribution capabilities for example. If they re a retailer. So the key point about return on capital employed is that it s a useful way of measuring the relative return ie profit on the amount that is invested either capital invested in the business.
So return on capital employed. Is sometimes shortened to roc roc. Er is a key a key ratio. Let s have a look at it.
In more detail and also have a think about why it s so useful firstly of course it s widely used because it s a measure of relative profitability. It gives you an indication as to how effectively a business is turning its capital invested into profit. It can also provide a very useful benchmark or target rate of return for individual projects. Within a business.
So when you come to look at investment appraisal. And you see the kind of returns that are being made the target rate of return may well be a target return on capital. Employed and return on capital employed..
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Is also very useful as a means of benchmarking. The financial performance of a business with closed competitors or with the industry as a whole to see whether that business is operating efficiently or has higher or lower profitability compared with the competition so a really useful ratio. How do you calculate it well it s a return and it s expressed as a percentage and strictly the calculation. It s calculated in different ways.
But strictly the calculation is this you take the operating profit of the business. More commonly the operating profit occasionally you may be asked to use net profit and you divide the operating profit of the business by the capital employed in the business. Which is defined as being the total equity in the business which we ll see in a second plus. The non current liabilities and both of those numbers on the bottom half of that calculation are drawn from the balance sheet of the business and of course operating profits.
You ll find in the income statements. Or otherwise known as the profit and loss account. Because it s a percentage of course once we ve done that little division. There we have to times.
It by hundred to express return on capital employed as a percentage. Number now let s have a little look at an example and on the screen. What i ve done is i ve listed out some of the summary information that you need to calculate return on capital employed. I ve done it for two sample or imaginary businesses company x.
And company. Y. Let s just briefly look after this information. A company x just working down.
The column. There has non current liabilities of five hundred thousand pounds and on the equity side. It has share capital of a million pounds and reserves retained profits of two hundred and fifty thousand pounds..
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So that makes total equity total. Equity share capital plus reserve s total equity of 125. Million. The operating profit business.
Which is drawn from the income statement. The operating profit is four hundred thousand pounds from the latest year. And you can see there s some different information for company y. It has a higher total equity as a result of a high level of reserves.
Four and half million and share capital of million making. Total equity of two and a half million. And it also has higher non current liabilities. It s usually debt of some sort of seven hundred thousand pounds so some slightly different information.
Now. If you don t have a calculator you return on capital employed. Before you have a look at the solution here. And why not just pause.
This video have a go and then when you ready start the video again. So let s have a look at the return on capital employed calculation. We said that it was operating profit divided by the total of total equity. Plus non current.
Liabilities. So in the case of company x are pressing profit of 400000. Pounds and we re going to divide that by..
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Adding together total equity of 125 million and non current liabilities of 500000. Pounds so 400 divided by 175. Million company y. A slightly different figure they have a higher rate or high level of operating profits.
But they also have higher capital employed two and a half million of equity plus. Seven hundred thousand of non current. Liabilities so you calculate six hundred divided by in that case two 32. Million.
And if you do the numbers in different times. It by 100 you can see that the return of capital employed of company x is 22 point eight percent. And that is actually higher than the return on capital employed of company y. Which comes in at eighteen point seven percent.
Now. That s interesting because the operating profit of the business of company. Y is much higher than company x. So how come it has a lower return on capital employed.
Well. The answer is because it has a lot more capital employed in the business. So whilst its profit. It s higher in absolute terms its absolute rate in return it s a relative rate of return rocker is lower.
Because it has so much more on the bottom half of that calculation as more capital employed therefore a lower return on capital employed. So hopefully you can see from that how return on capital employed is calculated now a few words just about how you would evaluate or how you can reuse this this useful financial measure firstly to say. It is very widely used and the beauty of it is because it uses published financial information from the income statement and the balance sheet..
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It s relatively easy to to calculate automatically from that information and to compare that information between competitors and between industries. So heads fragile analysts users return on capital employed. Quite widely. But it s important to remember of course that the percentage will definitely vary between industries.
Some industries have relatively low levels of profit and high levels of capital invested. Which would make the return on capital employed. Relatively low whereas others for example. The service sector has relatively little capital intensity.
But can have quite high profits and therefore you ll find when you compare service sector businesses with for example manufacturing businesses. The service sector usually has a higher level of return on capital employed of course. The other thing it remember is it s just based on a snapshot of financial information. So the bottom half of the calculation takes the latest balance sheet data.
When it works out to equity and non current liabilities. But of course. That s just a snapshot of the position of a business at a particular time where return on capital employed comes in really useful is to see in the case of an individual business. How it s changing over time for example it might be slowly rising.
Which will be good news. Which would see esday more profitable use of the capital invested in the business and of course. It s really useful for comparing the relative financial performances of closed competitors. There we go that s a brief introduction to an important financial.
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