Return on Capital Employed and Return on Equity
by Jim Shoesmith
Return on Capital Employed and Return on Equity are so interlinked that both these terms will be considered.
These Returns are, basically, simple and useful concepts; they have however been so manipulated (abused, some
people would say) over the past few decades that they now more often confuse rather than illuminate the
evaluation of company performance.
The concept of the Returns is intuitively valid and useful: what Return is being made on Capital Employed and
on Equity? In particular it is important to know whether the company is earning more than its cost of capital.
Simplistically, the Return on Capital Employed is the profit before interest and taxation (ie turnover less costs)
as a percentage of the capital employed in the business (ie fixed assets and net current assets) irrespective of
whether financed by shareholders equity or borrowings. It is a measure of the profit earned by the business
irrespective of how that business is financed.
Also simplistically, the Return on Equity is the profit after interest but before taxation (ie turnover less costs and
less interest paid) as a percentage of shareholders equity (capital employed less borrowings). It therefore only
differs from Return on Capital Employed as it takes account of the gearing achieved by borrowings.
The following simple example illustrates these definitions.
Tangible Fixed Assets
(Land, buildings, fixtures and fittings, plant and machinery etc)
Net Current Trading Assets
(Inventories, trade debtors, working balance of cash at bank less
Shareholders Equity Funds
Profit before Interest
(Turnover less costs)
Interest Paid on Borrowings (at 5%)
Profit after Interest
Return on Capit