The return on the capital employed is a financial indicator that is used to measure the proportion of adjusted earnings of the business to the amount of capital and debt that is used for the general operations and functions of the business. For a company to successfully run its business the return on capital must be greater then the capital employed within a business otherwise the earnings of the business will become lower that will result in a decrease in earnings per share of the shareholder.
In order to calculate the return on capital employed the earnings before interest and taxes are calculated. Another figure is calculated by subtracting current liabilities from the current assets. The earnings before interest and taxes is then divided with the above mentioned figure to calculate return on capital employed. The formula can be shown as under:-
Return on Capital Employed = Earnings before Interest and Taxes/ Total Assets – Current Liabilities
There are certain issues with the calculation of return on capital employed. One thing is that the current assets are used as denominator that include the current assets and associated depreciation. The current assets reduce with the passage of time which results in the creation of a high return on capital ratio. However this issue can be controlled if the company constantly replenishes its current assets by purchasing additional and new assets. The net result of this problem is that the older business has a high return on capital ratio as they have a smaller value in denominator. On the other hand the young businesses have a low return on capital employed ratio due to new assets and less accumulated depreciation results in the formation of a high value as a denominator.
Other Related Accounting Articles: