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. |