Price level changes often make the comparison of figures difficult over a period of time. Due to rising prices, the value of fixed assets continuously increases year after year. In such cases if any comparison is to be made, then proper adjustments for price level must be made. The assets acquired at different times are shown at the historical costs, as a result the financial analysis will not yield dependable results. A change in the price affects the validity of ratios calculated for different times.

Similarly, there may be two firms- one having purchased the assets at a lower price and another at a higher price. Return on investment calculated for these firms will differ substantially. The firm which purchased the assets at lower price, will show a higher rate of return than the firm which purchased the assets at a higher price. Therefore, results of inter-firm comparison may also not be dependable.

This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.

Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or Capital Employed = Fixed Assets + Current Assets – Current Liabilities

Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.

Example: Following is the Balance Sheet of Wye Ltd. as on December 31, 2004:

Find out the Return on Investment (Return on capital employed).

Workings

Net Profit before Interest = Rs. 5,00,000 + Rs. 1,00,000 (Interest on Loan) = Rs. 6,00,000

Capital Employed = Fixed Assets + Current Asset – Current Liabilities

= Rs. 29,00,00 + Rs. 25,00,000 – Rs. 15,00,000 = Rs. 39,00,000

Or

Capital Employed = Share Capital + Reserves and Surplus + Long-term Loans – Fictitious Assets

= Rs. 20,00,000 + Rs. 5,00,000 + Rs. 5,00,000 + Rs. 10,00,000 – Rs. 1,00,000 = Rs. 39,00,000