Examining Accounts: Business Ratios: Return on Capital
This ratio allows the comparison of the return on the capital employed in the business with the return on the same amount of capital placed in an investment account for the same period of time or employed in a similar business. It measures the earning power of the total long-term investment from all sources within an organisation. The ratio can provide a useful comparison between different traders in the same business area and the trader’s previous results over a period of time.
The ratio is referred to either as return on capital employed, return on investment or return on net assets and is calculated as follows:
- Operating Profit / Capital Employed
Operating profit is the reported net pre-tax profit plus any interest paid.
Capital employed is total assets less current liabilities as shown in the balance sheet. Either the average of the opening and closing capital figures or the end capital can be used in the calculation as long as all the other figures you intended to compare it with are calculated on the same basis.
If the figures are intended to be compared with other organisations then you will need to make sure that all of the computations value the assets of the respective organisations in the same way, at original cost, replacement cost or realisable value.
The method of valuing the assets generally depends upon the information available and the purposes for which the return on capital is being evaluated. The most common method of calculation uses the average capital employed method as this evens out any fluctuations and values the assets at original cost as this information is usually readily available.
Care needs to be taken when considering the resulting ratio. The results for director shareholders, of the return on capital employed need to be considered along with the total remuneration package including pensions, benefits and any share options granted. If the comparison you intend to make is between corporate and non corporate businesses and the company is a small close company where all the shareholders are directors then you may wish to consider adding the directors’ remuneration to the net operating profit before comparing the figures.
Return on tenants capital
A variation of return on capital employed is return on tenant’s capital which can be a useful ratio to consider where the trade is farming. This ratio looks only at the capital employed by the trader in terms other than land and buildings. Therefore even if the farmer is the owner-occupier the land and buildings are excluded from the calculation. This ratio is simply:
- Adjusted Operating Profit / Tenant’s Capital
In order to be able to make the comparison between farmers and between tenants and owner occupiers you will need to calculate a comparable operating profit and tenants capital figure. The capital figure is simply all assets except land and buildings. The operating profit for owner occupiers will need to be adjusted, either to include a notional rent or to exclude the costs of land purchase from the profit and loss account. This will depend upon the amount of information available in the Area. If the costs of land are excluded from the profit and loss account of an owner occupier for the purposes of comparison with a tenant then the rent in the tenants calculations should also be removed.
This ratio is relatively crude and therefore should only be used as a guide to identifying accounts where a more detailed review is likely to be required. It is recommended that it be used in conjunction with the gross margin and where information is available, with the gross output per hectare.