Return on Capital Employed
Chapter Thirty-Six
Syllabus topic 4, "Combined Ratio : i) Return on capital employed (Including Long Term Borrowings) ii) Return on proprietor's Fund (Shareholders Fund and Preference Capital) iii) Return on Equity Capital iv) Dividend Payout Ratio v) Debt Service Ratio vi) Debtors Turnover vii) Creditors Turnover (Practical Question on Ratio Analysis and Du Point Analysis)"
Pages 94 to 96 of 162
In one line
The return on capital employed is what the whole of the long-term money in the business earned, before it was divided between the lenders, the government and the owners.
The formula
Return on capital employed = (Profit before interest and tax / Capital employed) x 100
Expressed as a percentage. There is no statutory standard; it is judged against the cost of the capital, against last year, and against the trade.
| Element | What it is |
|---|---|
| Profit before interest and tax | Operating profit, plus net non-operating income, before interest and before tax |
| Capital employed | Proprietors' funds + long-term loan funds. Equally, fixed assets + investments + working capital |
Why the numerator must be before interest
Because the denominator includes the lenders' money.
| The capital employed includes | Whose reward is |
|---|---|
| Equity share capital and reserves | The residual profit |
| Preference share capital | The preference dividend |
| Long-term borrowings | The interest |
If the interest were deducted, the ratio would divide a return that excludes the lenders by a capital that includes them, and would understate what the business earned. Tax is excluded for the same reason: it is the government's share of the same earnings and is not a cost of using the capital.
That sentence is the whole answer to the question "why before interest and tax".
Worked on Sunrise
| 2026, Rs | 2027, Rs | |
|---|---|---|
| Operating profit | 2,80,000 | 3,60,000 |
| Add: non-operating income | 30,000 | 40,000 |
| Less: non-operating expenses | 10,000 | 20,000 |
| Profit before interest and tax | 3,00,000 | 3,80,000 |
| 2026, Rs | 2027, Rs | |
|---|---|---|
| Proprietors' funds | 13,40,000 | 15,00,000 |
| Long-term loan funds | 4,00,000 | 4,00,000 |
| Capital employed | 17,40,000 | 19,00,000 |
| 2026 | 2027 | |
|---|---|---|
| Return on capital employed | 17.24 per cent | 20.00 per cent |
And the proof of the capital employed from the other side, for 2027.
| Rs | |
|---|---|
| Fixed assets, net | 14,00,000 |
| Non-current investments | 1,00,000 |
| Working capital | 4,00,000 |
| Capital employed | 19,00,000 |
Prove it both ways in the answer. It costs three lines and it catches the commonest error in the question.
Interpretation
Sunrise earned 20 paise a year on every rupee of long-term capital in the business, up from 17.24. The improvement of nearly three points is substantial.
Where did it come from? The Du Pont chart answers that. The margin on PBIT rose from 18.75 to 19.00 per cent, and the capital turnover rose from 0.92 to 1.05 times. Both levers moved, and the turnover moved more, so the main cause is that the company produced more sales from the same capital.
And the test that matters: Sunrise pays 10 per cent on its debentures and earns 20 per cent on the capital employed. Every rupee borrowed earns twice what it costs, so borrowing more would raise the return to the equity holders. The debt equity ratio of 0.27 to 1 says there is room.
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