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Overall Profitability Ratio/Return on Investment (ROI):

Definition:

Overall profitability ratio is also called as "Return on Investments" (ROI). It indicates the percentage of return on the total capital employed in the business.

Formula:

It is calculated on the basis of the following formula:

(Operating profit / Capital employed) x 100

The term capital employed has been given different meanings by different accountants. Some of the popular meanings are as follows:

  • Sum total of all assets whether fixed or current.
  • Sum total of fixed assets.
  • Sum total of long-term funds employed in the business, i.e.,

Share Capital + Reserves and Surplus + Long-term Capital - (Non-business Assets + Fictitious Assets)

However, the term capital employed is generally used in the meanings given in the point third above.

The term 'Operating Profit' means 'Profit before interest and Tax'. The term 'Interest means 'Interest on long-term borrowings'. Interest on short-term borrowings will be deducted for computing operating profit. Non-trading incomes such as interest on Government securities or non-trading losses or expenses such as loss on account of fire, etc., will also be excluded.

The computation of return on investment (ROI) can be understood with the help of the following example:

Example:

From the following figures extracted from the Income Statement and the Balance Sheet of Messrs Ali & Sons Pvt. Ltd., calculate the Return on Total Capital employed or return on investment (ROI):

 

$

Fixed assets 4,50,000
Current assets 1,50,000
Investment in Govt. securities 1,00,000
Sales 5,00,000
Cost of goods sold 3,00,000
Share capital 3,00,000
Reserves 1,00,000
Debentures 1,00,000
Income from investments 10,000
Interest on debentures at 10%  
Provision for tax at 50% of net profits  

Solution:

It will be appropriate to prepare the Profit and Loss Account and Balance sheet of the company before computation of the 'return on capital employed (ROCE)'.


All & Sons Ltd. Profit and Loss Account

Details $ Details $
Cost of goods sold 3,00,000 Sales 50,00,000
Interest on debentures 10,000 Income from investments 1,50,000
Provision for taxation 1,00,000    
Net profit after tax 1,00,000    
 
 
  5,10,000   5,10,000
 
 

Balance Sheet As On

Liabilities $ Assets $
Share capital 3,00,000 Fixed assets 4,50,000
10% debentures 1,00,000 Current assets 1,50,000
Profit and loss account 1,00,000 Investment in Govt. Securities 1,00,000
Provision for taxation 1,00,000    
  1,00,000    
 
 
  7,00,000   7,00,000
   
 

Return on total capital employed = Net operating profit before interest and tax / Total capital employed

= 2,00,000 / 5,00,000 x 100 = 40 %

Net operating profit = Net profit + Provision for tax -  Income from investments + Interest on Debentures

= $1,00,000 + $1,00,000 - $10,000 + $l0,000

= $2,00,000

Capital employed = Fixed assets + Current assets - Provision for taxation

= $4,50,000 + $1,50,000 -$1,00,000

= $6,00,000 - $1,00,000

= $5,00,000

Return on Investment (ROI) can be computed for computing the return for different purpose. Some of the ratios that are calculated are as follows:

(1) Return on Shareholder's Funds:

In case, it is desired to work out the profitability of the company from the shareholders point of view, it should be computed as follows:

(Net Profit after Interest and Tax / Shareholders' funds) 100

The term Net Profit here means 'Net Income after Interest and Tax'. It is different from the 'Net Operating Profit' which is used for computing the 'Return on Total Capital Employed' in the business. This is because the shareholders are interested in Total Income after Tax including Net Non-operating Income (i.e., Non-operating Incomes Non-operating Expenses).

Taking the figures from the example above the Return on Shareholder's Funds can be computed as follows:

($1,00,000 / $5,00,000) 100

= 20 %

(2) Return on Gross Capital Employed:

The term Gross Capital employed means the total of Fixed Assets and the Current Assets employed in the business. The formula for its computation can be put as follows:

(Net profit before Interest and Tax / Gross Capital employed) 100

Gross capital employed = Fixed assets + Current assets

The students are advised to give their assumptions regarding computation of 'Net Profit' as well as 'Capital employed' while calculating the Return on Investment (ROI).

Average Capital Employed:

Some people prefer to use 'Average Capital employed' (or average total assets, as the case may be) in place of only 'Capital employed' (or Total Assets). Average Capital employed is the average of the capital employed at the beginning and at the end of the accounting period.

ROI = (Net profit before interest and tax / Average capital employed) 100
Average capital employed = (Opening capital employed + Ending capital employed) / 2

Important: It should be noted that while computing "Return on Investment" according to any of the above methods 'Abnormal Gains or Losses' should always be excluded from Net profit.

Significance Of Return on Investment (ROI):

The Return on Capital invested is a concept that measures the profit which a firm earns on investing a unit of capital. 'Yield on Capital' is another term employed to express the idea. It is desirable to ascertain this periodically. The profit being the net result of all operations the return on capital expresses all efficiencies or inefficiencies of a business collectively and, thus, is a dependable measure for judging its over all efficiency or inefficiency. On this basis, there can be comparison of the efficiency of one department with that of another, of one plant with that of another, one company with that of another and one industry with that of another. For this purpose, amount of the profits considered is that before making deductions on account of interest, income-tax and dividends and capital is aggregate of all the capital at the disposal of the company, vis., equity capital, reserves, debentures, etc.

The Return on Capital when calculate in this manner would also show whether the company's borrowing policy was economically wise and whether the capital had been employed fruitfully. Suppose, funds have been borrowed at 8% and the Return on Capital is 7.5%, it would have been better not to borrow (unless borrowing was vital for survival). It would also shoe that the firm had not been employing the funds efficiently.

The business can survive only when the return on capital employed is more than the cost of capital employed in the business.




 

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