Return on Capital Employed: Computing the Return on the Base

Return on capital employed divides operating profit by the capital employed in the business, giving the percentage return that the long-term funding produced before financing costs and tax. Operating profit belongs on top because the base holds money from lenders and owners together, so the return is measured before either is paid. The base may be opening, closing or average, and the choice must be stated.

Underneath that sit one profit figure, one base figure, one division, and three decisions that must be made before the division is worth anything. A set of accounts prints four or five profit lines and only one matches the base, so the first decision is which line is lifted. The second is which of two routes builds the base. Both routes must land on the same amount, and disagreeing routes mean a line has been mis-picked. The third is whether the base is the one at the start of the year, the one at the end, or the average of the two. The same profit divided by three different bases gives three different percentages, and none of them is wrong on its own. The arithmetic is one division. The work is the three decisions.

Every input is read from an exact printed line, the base of Anjani Stationers, an invented business, is built by both routes until they agree, the year two figure of 27.3 per cent and the assumed year one figure of 44.9 per cent follow, the fall between the two years splits into the part the profit caused and the part the base caused, and one wrong numeratorThe number sitting on top of a division, the quantity being divided by something else. turns 27.3 per cent into 19.7 per cent. What capital employed is falls under capital employed, and what any finished figure ought to be falls under the foundations vocabulary.

What does this ratio answer?

The ratio answers one question: of every hundred rupees of long-term funding sitting inside the business, how many rupees of operating profit did the year produce? The answer is a share, not an amount, and the whole reason anyone runs the division is that shares can be set beside each other while amounts cannot. Consider a cousin who says her tailoring unit made Rs 3,00,000 of operating profit last year. Nothing can be done with that sentence. The sentence becomes usable the instant she adds what is tied up in the unit: on Rs 10,00,000 of machines, stock and working funds the figure reads one way, on Rs 40,00,000 it reads a quarter of that, and only the division says which of the two is in front of the reader. The same sentence with two different bases underneath describes two completely different years.

Return on capital employed is not a figure printed anywhere in a set of accounts, it is a division performed after the year is over, and both of its inputs are already printed before the division begins. That rules several things out. No ratio is printed in the statements, so there is none to hunt for. No percentage is applied to anything. One amount comes off the statement of profit and loss and one amount is built from the balance sheet, the first goes over the second, and the result reads as a percentage. For Anjani Stationers in year two those two amounts are an operating profit of Rs 41,50,000 and a capital employed of Rs 1,52,00,000, and the division gives 27.3 per cent.

Why must the profit on top be measured before lenders and tax?

Because of who put the base there. Capital employed for Anjani Stationers is Rs 1,52,00,000, and that amount is made up of Rs 1,42,00,000 of equity and Rs 10,00,000 of non-current liabilities. Two sets of people funded it. The lenders funded the Rs 10,00,000 and are paid through the finance cost. The owners funded the Rs 1,42,00,000 and are paid out of what is left after the finance cost and the tax charge. If the base counts both of them, the profit measured against it has to be taken at a point on the statement before either has been paid, and that point is the operating profit line.

The rule that governs this whole computation is that the numerator and the denominatorThe number underneath the line in a division, the quantity the top number is being divided by. must describe the same set of claimants, and every common mistake in the computation is a breach of exactly that rule. The household version makes the shape obvious. Suppose four cousins jointly buy a delivery van for Rs 6,00,000, of which Rs 5,00,000 is their own money and Rs 1,00,000 is a loan from an uncle who charges interest. At the end of the year they want to know what the van earned on the whole Rs 6,00,000. The uncle's Rs 1,00,000 is inside the Rs 6,00,000 they are dividing by, so the cousins must take the van's earnings before the uncle's interest is handed over. Taking the earnings after the interest measures what four people got on money six people put in. The finance version is identical, and the only thing that changes is the vocabulary.

What goes on top, and where is it found?

The operating profit, and it is printed on the faceThe main printed statement itself, as opposed to the numbered notes that sit behind it and break its lines into parts. of the statement of profit and loss, on the subtotal line that sits above the finance cost. The face of the statement is the only place to look. The caption varies between preparers: Operating profit, Profit before interest and tax, or Earnings before interest and tax (EBIT). All four captions name the same subtotal in the same position on the ladder, and the test that the right line has been found is the one directly below: the next line down should be the finance cost, and the one after that the profit before tax.

The numerator is a printed subtotal and not something assembled, so the first check on any return on capital employed is that the amount on top was lifted straight off the face rather than built out of other lines. Four amounts on this statement are all called profit and are not the same figure. Operating profit of Rs 41,50,000 is the one this ratio uses. Profit before tax of Rs 38,00,000 sits one line lower, after the lenders have been paid. Profit after tax of Rs 30,00,000 sits two lines lower still, after the tax authority has been paid. Gross profit sits far higher up, before the running costs of the business have been taken off at all. Only the first of those four is a pre-taxMeasured at a point before the tax charge has been taken off, so the amount still includes what will later go in tax. figure that also sits above the finance cost. Pick any of the three wrong ones and the division will still work perfectly and answer a question nobody asked.

The abbreviation invites one clarification. Most Indian statements present EBIT and operating profit as the same printed subtotal, and the computation treats them so. Where a statement shows other income, an exceptional item or a share of results from another business between the operating line and the finance cost, the amount required is the one the finance cost is actually deducted from, and where that is unclear, following the subtractions down the statement settles it more reliably than the caption. For Anjani Stationers there is nothing between the two lines, so the operating profit of Rs 41,50,000 goes straight onto the top.

What goes underneath, and where is it found?

The capital employed, and it is not printed anywhere, so it is built from the balance sheet by one of two routes and checked by the other. Route one starts at the top of the balance sheet: take total assets and subtract the current liabilitiesAmounts a business is due to settle within its ordinary operating year, listed together as a subtotal on the balance sheet.. Route two starts at the bottom: take the equity total and add the non-current liabilities. For Anjani Stationers route one is Rs 1,80,00,000 less Rs 28,00,000, and route two is Rs 1,42,00,000 plus Rs 10,00,000. Both give Rs 1,52,00,000.

A base that is Rs 4,00,000 wrong looks exactly as convincing on the statement as a base that is right, so running both routes is not a nicety. It is the only self-check this computation has. The two routes touch different lines. Route one touches total assets and the current liabilities subtotal. Route two touches equity and the non-current liabilities subtotal. No single slip would move both routes by the same amount in the same direction, so if they agree, every line was read correctly. If they disagree, the difference shows where to look: a gap the size of a lease liability usually means the split of that liability between the current and non-current subtotals was misread, and a gap the size of the whole equity means a subtotal was taken where a total was needed.

Where does each of the four amounts appear? Total assets is the final line of the assets half, printed as a total. Current liabilities is a subtotal inside the liabilities half, printed above the non-current group. Equity is the total of the equity section, share capital plus retained earnings. Non-current liabilities is the other subtotal in the liabilities half. All four are printed. None of them is computed by the analyst, and where a balance sheet does not print the two liability subtotals separately, the split is in the note behind the liabilities line and is taken from there rather than estimated.

Opening, closing or average base, and why must the choice be stated?

Because the profit was earned across a whole year while the balance sheet was photographed on one day of it. Anjani Stationers' operating profit of Rs 41,50,000 accumulated over twelve months, during which the capital employed moved from Rs 1,18,00,000 at the start to Rs 1,52,00,000 at the end. Neither of those two amounts was in place for the whole year. So there are three defensible bases, and each one produces a different reading of exactly the same year.

The three bases give 35.2 per cent, 30.7 per cent and 27.3 per cent for one unchanged year of trading, a spread of nearly eight percentage pointsThe unit used for the gap between two percentages. Moving from 27 per cent to 30 per cent is a rise of three percentage points.. The spread is why the base timing must be written down beside the answer rather than assumed. The opening base of Rs 1,18,00,000 gives 35.2 per cent, and it reads high because the year's profit is measured against the funding that was there before the year's growth arrived. The closing base of Rs 1,52,00,000 gives 27.3 per cent, and it reads low because the profit is measured against funding that only reached that level on the last day. The average base of Rs 1,35,00,000, computed as Rs 1,18,00,000 plus Rs 1,52,00,000 divided by two, gives 30.7 per cent and sits between them by construction.

None of the three is the correct one and the choice is a convention, not a calculation. Stating which convention was used is not optional. ComparabilityWhether two figures were built the same way, so that setting them side by side actually means something. lives entirely in that sentence. Set a closing-base figure for one business beside an average-base figure for another and the comparison is decided by the convention rather than by the trading. In practice the closing base is the simplest to compute and the one most people reach for when only one balance sheet is available. The average base is the one people prefer when the funding moved a lot during the year, and for Anjani Stationers it plainly did. The calculator below computes all three and leaves the convention as a stated input.

What does Anjani Stationers' calculation give for both years?

The whole computation follows, laid out as the inputs, their sources and the divisions they feed. The middle column is an instruction: it says where to look on the printed accounts, and nothing more than that. Year two is taken from the reported statements. The earlier balance sheet was not built to this level of detail, so year one is taken from an assumed base and an assumed operating profit, both labelled assumed wherever they appear.

The reading fell 17.6 percentage points between the two years. The operating profit dropping by Rs 11,50,000 did the larger part of that, and the base rising by Rs 34,00,000 did very nearly as much. A reader who sees only the two finished percentages will reach for the profit as the whole explanation every single time, and here the profit is a little over half the story, so the split is worth working through slowly. Hold the base at the year one figure of Rs 1,18,00,000 and change only the profit: Rs 41,50,000 over Rs 1,18,00,000 is 35.2 per cent, so the profit falling cost 9.7 percentage points. Now change the base as well: Rs 41,50,000 over Rs 1,52,00,000 is 27.3 per cent, so the base rising cost a further 7.9 percentage points. The two effects add to 17.6, the whole fall. The base accounts for 45 per cent of it despite never appearing on the statement of profit and loss at all.

The decomposition is arithmetic, and it will reproduce every time on these figures. The decomposition is not a finding about the business. A base that grew by Rs 34,00,000 could have grown for any number of reasons; the accounts show which lines moved but not why anybody moved them, and whether a falling reading is a problem or the ordinary shape of a year in which funding was put in ahead of the trading it was meant to support is a separate question. The arithmetic establishes a defensible pair of percentages, the convention they were computed on, and an honest split of the distance between them.

The readings the calculator produces run as follows. On the closing base of Rs 1,52,00,000 the slider runs from 13.2 per cent at an operating profit of Rs 20,00,000, through the reported 27.3 per cent at Rs 41,50,000, to 39.5 per cent at Rs 60,00,000. On the average base of Rs 1,35,00,000 the same three profits read 14.8, 30.7 and 44.4 per cent. On the opening base of Rs 1,18,00,000 they read 16.9, 35.2 and 50.8 per cent. Pick the opening base and the attribution strip collapses to nothing. The year two division is then using the very same base the year one division used, so every point of difference between the two years has to come from the profit. The collapse is the cleanest demonstration of why the base timing is an input rather than a detail: it decides how much of a year-on-year move can be attributed to trading at all.

Who computes this ratio, and what do they do with it next?

Nobody performs this division for its own sake. Four kinds of reader compute it regularly and each does something different with the result, and which of the four is at work decides the base timing chosen before the arithmetic starts. The closing base is the funding the business is carrying into the period a facility would sit in, so a lender assessing a term facility computes it on the closing base. An analyst comparing one business against another computes it on whichever base the other business used, and if that is not stated, computes both and says so. Somebody assessing a proposal to put more funding in computes it on the base as it would be after the funding arrives. The result is a closing-base calculation on a balance sheet that has not been drawn up yet, and it must be labelled as such.

Convention alone does not choose the base timing. The reader's next step chooses it, and a reader who cannot name that next step is not ready to pick a base. The household version is exactly the same decision. A cousin who has run her tailoring unit for three years and wants to compare this year with last year needs the same convention in both years, whichever one she picks. A cousin deciding whether to put another Rs 2,00,000 into the unit needs the base that includes the Rs 2,00,000, the base her money would be joining. Same unit, same profit, two different bases, and neither of them is a mistake.

One boundary is the thing readers most often expect this arithmetic to supply. A percentage on its own has no target attached to it. What return a business should be aiming for is covered under the foundations vocabulary.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.