Return on capital employed: Advantages and disadvantages of ratio analysis
Return on capital employed ration analysis helps in identifying the current financial position of a business. It is not always easy for us to find out the company’s present position by going through it balance sheet only. Balance sheet only offers few transaction figures and based on those figures it becomes difficult to take any decision regarding the strategy planning of the business. Hence ratio analysis becomes important.The Return on capital employed ratio is identified as the best way to measure the profitability of any business.
Return on capital employed: Importance of ratio analysis
The return on capital employed ratio allows a United Kingdom based business house to understand the strengths or weakness of a company.
Different types of ratios are
- Profitability and return ratio
- Long term solvency and stability ratio
- Short term solvency and liquidity
- Efficiency (turnover ratios)
- Shareholder’s investment ratio
Ratio analyses helps in going through a comparison study of the business. This profit comparison study is based on yearly profitability of the business.
Return on capital employed: A process of interpreting the company’s account
Along with the Return on capital employed analysis the management has to look into, various reports drafted by the company chairperson, analyze the wear and tear of the assets, and go through the detailed report about the company’s share and financial condition in the market. Thus, with the help of this ratio analysis, you can prepare a suitable business strategy plan for your firm.
Return on capital employed: To calculate the ratio, you must follow the below mentioned formula – Return on capital employed = Profit on ordinary activities before interest and taxation / Capital employed
Capital employed = shareholders’ funds plus creditors: amounts falling due after more than one year’ plus any long term provisions for liabilities and charges.
Return on capital employed develops a relationship between the profit and the capital utilized.
Return on capital employed: Tips to be followed while calculating the ratio
· Evaluate the fixed assets of the company based on their replacement price. Under this replacement cost fixed assets must be valued as per the present market price of the asset.
· Exclude all idle assets which are not regularly used in the business. Such items should not be included in the capital invested in the firm.
· You must rightly value all current assets of the firm. Do check that there is no excess amount of cash left in your business. Your motto should be optimum utilization of the profit.
· Do exclude intangible assets like, patents, goodwill, rights, and trade marks from the ratio analysis.
· Do value all your current assets properly.
· Do not include the obsolete assets since they add no value to the business.
There are people who think that average capital invested should be used to offer complete effect to the capital investment and it will be utilized throughout the year.
As said they help in understanding the profitability of the business properly and allow you to take proper decision regarding framing business strategies. So, never forget about the Return on capital employed ratio in a business.