Definition: The Return on Capital Employed Ratio measures the profits generated from each capital employed. Unlike return on equity that measures only the company’s common equity, the return on capital employed is a comprehensive approach that measures the overall financial performance of the company, by taking both the equity and the liabilities into consideration.
The return on capital employed is best suited when comparing the performance of the companies in the capital- intensive industries.The company’s return should be more than the rate at which the funds are borrowed from the investors.
The formula to calculate this ratio is:
Return on Capital Employed = Net Operating Profit/ Capital Employed
Where, Net Operating Profit is equivalent to earnings before interest and taxes (EBIT) and Capital Employed = Total Assets – Current Liabilities or shareholder’s equity – long-term liabilities.
A Higher value of return on capital employed ratio shows more revenue is generated with the capital employed and hence better returns are given to the investors.
Example: Suppose a firm has a net operating profit of Rs 25,000 and has reported Rs 1,50,000 and Rs 50,000 as total assets and current liabilities respectively. Then the Return on Capital Employed will be:
Return on Capital Employed = 25,000/1,00,000 = 0.25 or 25%
[ Capital employed = 1,50,000 – 50,000 = 1,00,000]