The gross profit and net profit margin ratios show how profitable a business is but these
ratios do not give an indication on how much the returns of a business is compared to the
amount of funds invested.
I’m Thomas Harwood and Welcome to The Accounting Student, where we create free and short videos
so that you can learn about accounting.
Today’s video is looking at the return on capital employed ratio.
As mentioned in our previous videos on the accounting ratios, that without the use of
the accounting ratios, the financial statements such as the income statement and balance sheet
would be very unhelpful to most people, except for those who are proficient in accounting
or business.
The accounting ratios have a vital role in satisfying the needs of the users of the financial
statements. As a result of using the ratios, the statements of a business can be easily
understood and be of valuable use to those reading them.
The ratios are used to assess or liken financial data and will allow the user to gain an understanding
into how a business is performing from one period to another or how a business is performing
against another business.
In common practice, the accounting ratios can be sorted into three main groups and they
are profitability, liquidity and efficiency.
Profitability ratios consider the profits and returns of the business. Furthermore,
the profitability ratios are split further into three main ratios.
They are the gross profit margin ratio, the net profit margin ratio and the return on
capital employed ratio. The first two ratios have the links for their videos in the description
below. And in this video, we are going to look at the latter ratio.
The return on capital employed ratio which is also known as ROCE is arguably the most
important ratio of the profitability ratios. This ratio indicates how effective a business
generates profit given the amount of funding that has been invested into the business.
Return on Capital Employed is calculated by dividing the net profit by the capital employed
and this value is times by 100 to give the result as a percent.
ROCE is particularly helpful for individuals who are planning or looking to invest into
a business. The ratio gives the person an indication into what return they would expect
to receive.
For example, a ROCE of 6% means that if the person invested in the business they would
expect to receive 6 pence for every £1 invested in the business.
From this outcome, the person can then compare the expected returns of other investments
before deciding on what they would like to invest in.
Similar to the other profitability ratios, the higher the ROCE is, the better it is.
However, in terms of ROCE, risk should also be considered.
Let’s revisit the example which was in our last two videos.
Tim has a toy shop and the main product sold during the year was a rocket ship. He recently
sold a rocket ship, and we had to calculate the gross profit and net profit margin for
the rocket, which was 20% and 8.33% respectively.
Tim’s friend, Ian, has £10,000 in the bank which he is thinking of investing to increase
his returns. Currently he has a savings account with the bank which he receives interest of
5% per year.
Tim has spoken to Ian about investing in his toy shop. Tim estimated, that based on previous
years returns that if Ian invested £10,000 he would receive a net profit share of £1,050.
Additionally Ian would have to pay business fees of £350 on the net profit share.
What would be the best investment for Ian?
First, we would workout the ROCE for each option.
We have already been given the ROCE for the bank savings account which is 5%.
As with the investment in the toy shop the net profit received for Ian would be the initial
£1,050 minus the £350 of business fees. This would then result in Ian receiving actual
returns of £700. If we then calculate this in terms of ROCE we will have £700 divide
by £10,000 times by 100 which equals to 7%.
So, in comparing the returns of the investments. Ian would receive returns of 5% if he kept
the funds in the bank savings account and if invested into Tim’s toy shop he would
receive returns of 7%.
Going back to the question on what would be the best investment for Ian? Both options
have similar returns with only small difference of two percent. If Ian was looking to gain
the maximum amount of return, then the best option would be to invest in the toy shop.
But Ian should consider two important things. Firstly, is 7% the normal return in the toy
sector? If so the investment is ok but if there are other toy shops that return more,
then he should opt for them if the risk is the same.
The second thing to consider, is the risk involved, Ian should think about the risk
he wants to take with his investment. Banks are seen as a “safe” option when investing
so if Ian would prefer to limit the risk he takes, then he should keep the funds in the
savings account but if he wants to risk more, to potentially earn more and probably because
he knows Tim and trusts him, then he should consider investing in the toy shop.
So that was the explanation of the return on capital employed ratio. If you enjoyed
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Thanks for watching we’ll see you next time.