16.CHAPTER 4: RATIO ANALYSIS: PROFITABILITY RATIOS : RETURN ON INVESTMENT (ROI) OR RETURN ON CAPITAL EMPLOYED (ROE) ASSIGNMENT # 9

LEARNING OUTCOMES:

INTRODUCTION

THE PROFITABILITY RATIO:

 RETURN ON CAPITAL EMPLOYED (ROI)

                        OR

 RETURN ON CAPITAL EMPLOYED (ROE)

FORMULA OF THE RATIO

THE APPLICATION OF THE RATIO

ITEMS OF THE NUMERATOR AND DENOMINATOR OF THE RATIO

 Return on investment (ROI)

                     Or 

Return on capital employed (ROCE) 

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                                                     ↓     

RETURN ON INVESTMENT OR RETURN ON CAPITAL EMPLOYED

It explains the overall utilisation of funds by a business enterprise.

 It is calculated as

= Net profit before interest and tax divided by Capital employed × 100

Capital employed means:  the long-term funds employed in the business and include shareholders' funds and long-term debt.

Thus, Capital employed = Shareholders' funds + Long term debts (Non current liabilities) 

Alternatively,

 Capital employed = Non current assets + Working capital

*Balance sheet equation: Equity and liabilities = Total assets *

*Shareholders funds + Non current liabilities + Current liabilities = Non-current asset + Current asset

* Shareholders funds + Non current liabilities = Non-current asset + Current asset - Current liabilities

* Capital employed = Non-current asset + Working capital

Significance:

Return on investment measures return on capital employed in the business.

 It reveals the efficiency of the business in utilisation of funds entrusted to it by the shareholders, debenture holders and long term loans. 

For inter firm comparison, ROI is considered a good measure of profitability.

It also helps measures in assessing whether the firm is earning a higher ROI as compared to the interest rate paid on long term debts.

 This is so because if ROI > Rate of interest on debt, it is advantages for a company to use more debt to increase. 

Earning per share (trading on equity).

Ques 1   (EXAMPLE)

From the following details, calculate Return on investment:

Share capital: Equity (Rs.10)               400000

12% Preference                                   100000 

Reserves and surplus                           184000
10% Debentures                                   400000
Current liabilities                                 100000
Fixed assets                                         950000
Current assets                                      234000

Additional information:

 Net profit after tax was 150000. Tax @ 25%

8.61

Net profit before tax =     Net profit after tax

                                        ________________           x 100 

                                          100 - tax rate 

= 150000

    _______   x 100

         75 

 = 2 lakh 

Interest on debentures= 10% of 400000 = 40000 

Therefore, 

Net profit before interest and tax = Net profit before tax + Interest on debentures

=200000 + 40000= 240000

Now, 

Capital Employed =Shareholders funds + Non current liabilities 

= (Equity share capital + Preference share capital + Reserves and Surplus) + 10% Debentures
= (4 lakh + one lakh + 184000) + 4 lakh = 1084000 

Alternatively,

Capital employed = non current assets + working capital 

=Fixed assets +( Current assets minus Current liabilities)
= 950000 + (234000 - 100000) = 1084000 

Therefore, Return on Investment = Net profit before Interest and Tax

                                                         ____________________________   x 100 

                                                                     Capital employed 

= 240000

  ________  x 100 

   1084000 

 = 22.14 %

ASSIGNMENT # 9

Ques 1. (DO IT YOURSELF)

Calculate Return on Capital Employed

Net profit after tax              100000
10% Long term borrowings  500000
Share capital                        150000
Tax rate                                     50%

Ans 331/3%

IMPORTANT NOTE:

Beside the notes(study material) formulas, examples, assignments, solutions to the assignments etc.

I am sharing with you the TS Grewal's Accountancy text book, 

there are numerous problems with its solution.You can make the best use of time. Solve, Practice, Master the concepts and gain Confidence.

CLICK BELOW FOR THE LINK

ANALYSIS OF FINANCIAL STATEMENTS BY TS GREWAL

CONCLUDING NOTE:

HOPE  YOU FOLLOWED THE DERIVATIONS OF THE FORMULAS OF RATIO ANALYSIS. AND WILL MAKE THE BEST USE OF THE T.S. GREWAL LINK SENT FOR CHAPTER 3 (TOOLS OF FINANCIAL STATEMENTS ANALYSIS)



ANSWER TO ASSIGNMENT # 9

Return on capital employed =Net profit before interest and tax
                                              ____________________________       x 100 
                                                      Capital employed 

Net profit before tax =Net profit after tax                                                                                                             _________________     x 100 
                                           100 - tax rate  
= 100000
   _______   x 100 
    100 - 50 
=2 lakh
Therefore, Net profit before interest and tax= Net profit before tax + Interest on long term borrowings
= 200000 + 10% of 5 lakh =2 lakh + 50,000
= 250000
Capital employed =Shareholders funds (share capital + balance in profit and loss statement i.e net profit after tax) + Non current liabilities (10% long term borrowings) = (150000 + 100000) + 5 lakh 
= 750000
Therefore, Return on capital employed 
= 250000 /750000 x 100 
= 331/3%

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