Return On Capital Employed Ratio

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Return on Capital Employed Ratio

Meaning: This ratio, also known as return on investments, is a basic ratio of profitability. It is calculated by establishing a relationship between the profit earned and the capital employed to earn the profit. This ratio is generally stated in the form of percentage with a view to ascertain how much profit a firm has earned with the use fo Rs. 100 of capital. It is therefore an indicator of the earning capacity of the capital invested in the business. It is calculated as:

Return on Capital Employed:
[Profit before interest, tax and dividend / Capital employed x 100

The given net profit figure is adjusted by adding back to the net profit the interest paid on debentures and other long-term loans, and abnormal losses, e.g., loss by fire, loss on sale of fixed assets and so on. Similarly, abnormal or non-recurring gains such as gain not the sale of fixed or long-term assets must be clearly stated. Capital employed can be computed by any of the given two methods: First method: Equity share capital plus Preference share capital plus Reserves and surplus plus Long-term loans minus Fictitious assets and Non-operating like investments made outside the business. Second method: Fixed assets net of depreciation plus working capital, i.e., current assets minus current liabilities.

Significance: (i) The ratio measures the overall profitability of a business enterprise. It shows how efficiently the sources committed to the business are being utilized. (ii) This ratio also enables to find out how efficiency the borrowed funds are being employed by the management so as to provide additional income to the equity shareholders by trading on equity (iii) Similarly this ratio is useful in making capital budgeting decisions since a project giving higher return will be undertaken. (iv)  This ratio is also very significant measure for inter-firm comparison and for evaluation of the various departments within a firm. (v) Moreover, this ratio can also be used in judging the efficiency of two different units of the same business enterprise. (vi) This ratio can be used for determining the price of the product of the firm. In other words, the price fo the product should be fixed in such a way that the price recovers not only the cost of the product but ensures a reasonable rate fo return. (vii) This ratio can be usefully employed in planning the capital structure of the firm. It means that management should not depend on borrowed funds if it is not in a position to earn more than what is payable as a fixed charge on such funds.

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