For any business entity, the ultimate goal is to generate profits. No business operates on charity; instead, it expects adequate returns in exchange for the operations it undertakes. Profitability and capital efficiency are therefore key concerns for any firm. Return on Investment (ROI) or Return on Capital Employed (ROCE) are important financial metrics used to measure the overall profitability of a business and to assess how efficiently the firm is utilizing its invested capital to generate returns.
Return on Investment (R.O.I) or Return on Capital Employed
Return on Investment (ROI), also known as Return on Capital Employed (ROCE), is a profitability ratio that measures how efficiently a business uses its capital to generate profit. It compares the total profit earned with the total capital invested in the business, showing the overall return generated from the funds employed. This ratio is often expressed as a percentage and is also referred to as the rate of return or yield on capital. For its calculation, profit before interest, tax, and dividends is considered, while capital employed refers to the long-term funds invested in the business, mainly contributed by shareholders. A higher ROI or ROCE indicates better utilization of capital and stronger financial performance of the business.
Formula:
Where,
Capital Employed = Shareholder's Fund + Long-term Debts
or
Capital Employed = Total Assets - Current Liabilities
or
Capital Employed = Fixed Assets + Current Assets - Current Liabilities
or
Capital Employed = Fixed Assets + Working Capital
Significance
- Since any business's main goal is to earn profits, so this goal best aligns with what exactly the overall profitability ratio measures. The profitability ratio gives the best criteria to measure the comprehensive performance of the business.
- This ratio helps to determine the profit-yielding capacity of the net investments or the assets employed in the business enterprise.
- This ratio also serves the purpose of having a comparative analysis of two business enterprises that are dissimilar to each other. Through the profitability ratios of both enterprises, the performance of both enterprises can be analysed against each other.
- Moreover, this ratio can also be used to determine the borrowing policy or capacity of any business entity. For example, if the profitability ratio for the business comes out to be 18% and the borrowing rate is 20%, it indicates that the borrowing rate is higher than the return on investment.
- Calculation of R.O.I. also helps to decide if the business is performing its operations in the right direction and if there is any diversion, then what are the areas that require more improvement.
Illustration 1:
The financial statement of Radhey Shyam as on March 31, 2022 is as follows:
-1.png)
Notes:
1. Reserves & Surplus:
- Reserves = ₹5,00,000
- Profits (After Interest) = ₹17,00,000
2. Long-term Borrowings (on 10%)= ₹15,00,000
3. Other Current Assets:
Share Issue Expenses = ₹11,00,000
Calculate Return on Investment.
Solution:
So, Profit before Interest = Total Profit + Interest on Long-term Borrowings
= 17,00,000 + 1,50,000
= ₹18,50,000
Capital Invested = Share Capital + Reserves & Surplus + Long-term Borrowings - Share Issue Expenses
= 25,00,000 + 22,00,000 + 15,00,000 - 11,00,000
= ₹51,00,000
So,
= 36.27%
Illustration 2:
Following are the financial details of XYZ ltd:
-2.png)
Find out the Return on Capital Employed.
Solution:
Profit before interest and tax = Net Profit + Interest on Borrowings
= 1,00,000 + 42,000
= ₹1,42,000
Capital Employed = Equity Share Capital + Preference Share Capital + Reserves & Surplus + Long-term Borrowings - Discount on Shares + Net Profits
= 4,20,000 + 1,20,000 + 2,95,000 + 4,20,000 - 25,000 + 1,00,000
= ₹13,30,000
= 10.67 %