Return on Capital Employed

How to think about return on capital

I don’t have any formal finance/accounting education so I need to figure out a lot of things for myself. This is how I look at capital employed by a business. Let’s consider a simple business such as property rental. It’s important to distinguish between myself and the business - these are two completely different perspectives.

Step 1: I own 100% of a business (let’s call it MB Ltd) and I have some funding for it - say one million pounds. I’ll put it all into the business. On the balance sheet below MB Ltd will have cash of £1m and corresponding equity.

Step 2: MB Ltd buys a property for £800,000. It now has on its balance sheet a Property (it would be Plant, Property & Equipment - aka PPE on a real balance sheet) in the Non-current assets section. Cash has reduced to £200k. MB Ltd has now also rented the property out for £90,000 per year.

Step 3: MB Ltd doesn’t want to have all this cash invested in the property so it takes out a loan to refinance the purchase. This will get reflected by increasing the cash balance and introducing a Long-term debt item in the Non-current liabilities section. The loan costs £10k in interest per year.

Step 4: MB Ltd now has too much cash in the business which it doesn’t have any use for so it will return it to the investor. MB Ltd returns £600k. Notice how that decreased the equity of the business.

Let’s now have a look at what happens to the return on capital.

In Step 1 MB Ltd had no income so no return on capital. In step 2 it had income of £90k making the return 9% per annum (p.a.)

After taking out the loan in Step 3 the return decreased to 5%. This is because the the capital employed increased to £1.5 million and also because the income decreased to £80k - MB Ltd has to pay interest on the loan.

Finally, in Step 4 the return on capital went back up to ~ 9% because the capital employed went down.

That was all from the perspective of the business. If I look at it from my perspective as the investor.

There was probably Step 0 at some point when the investor had £1m before putting it into the business. The below illustrates the investor’s return on equity - i.e. his share of ownership - this would be the case if the business distributed all the net income back to the investor. In real life that’s rarely the case though.

Interestingly the return on equity for the owner has gone up significantly after the MB Ltd took out the loan and returned cash in Step 4. Overall, not much has changed for the owner though as he now has £600k that is sitting idly not making any money until it gets deployed into some new business.

From the business’s perspective Return on capital has not changed much though after taking out the loan. It seems it can’t influence the return on capital by using leverage. By using leverage it can deploy larger amounts of money with the same return on capital.

The important takeaway from this is that it’s key to only invest in businesses that have high return on capital and have ongoing opportunities for deploying it.