Return on capital:
Return on capital or return on equity invested or capital employed is the percentage return on investment. The return is generated from the profit the business makes from its activities. This is the formula for calculation of return on capital employed:
Return on Capital Employed is calculated by Earning Before Interest and Tax / Capital Employed
To understand how we can improve the return we generate from the capital employed, it is also important to look at what we’re investing in. Investments can be stocks, bonds, mutual funds, real estate or interest-bearing accounts, etc.
Some investments are much riskier than others while some investments yield a much greater return than others. Most investors prefer more return and less risk.
How to improve return on capital employed?
Now moving on to how we can improve our return we yield on our investments- there are multiple ways to do so. Let take a look at the most effective ways.
- Reduce costs and increase sales: By reducing costs, sales value will increase and greater sales will lead to more profit being generated. This can’t be done simply by spending less but finding out about the nature of each cost and how it affects the selling price and profits. Lowering the selling price won’t be the only solution if costs aren’t being reduced too. But higher sales don’t necessarily mean higher profits or higher returns. By reducing costs, the company can become more efficient too if they try to find areas where unnecessary costs are being generated. This will lead to operational efficiency as well. We need to analyze how much percentage change the reduction of each cost brings in the sales and evaluate the percentage increase in profits due to the reduction in cost percentage. Hence, the combination of lower costs and higher sales will provide a better return on capital.
- Disposal of assets: Selling off surplus assets and inefficient assets that don’t generate much revenue or increase costs can also improve your return on capital employed. Assets that cost more than they generally are of no use to any business. For example, a production company should sell off the machine that has outlived its efficient days. This way there will be less capital employed and more returns leading to a better return on capital employed percentage.
- Level of operation: The scale at which the business operates is also very important to look at while talking about return on capital. If the business is small scale, it will have high fixed costs and the return will be lower. However, if the business is high scale and increasing the volume can reduce fixed costs, the business should be doing so in order to maximize profits. This is also known as economies of scale.
- Debt financing: Furthermore, the company should try to finance its business through debt financing rather than equity financing. Equity financing dilutes shareholders holding since the number of shareholder increases meaning the net profit would be distributed among a higher number of investors.
A perfect combination of all these ways can lead to a better return. Many things go overlooked in business and to have the maximum return generated on all the capital invested, a company should analyze each and every aspect of its business.
Return on capital employed tells the shareholders the value of a company and how profitable the company is. A higher return is obviously better but we can’t judge the value and performance of a company by looking at just one figure.
The trends of many ratios over the years and across the industry has to be taken into consideration.
Just generating lots of profit with no actual efficient operations taking place in the business will lead to a greater return, but when taking the bigger picture into account, it is a loss for business because of the inefficiency.