Return on capital is a powerful but simple tool says Ian Neal

A useful and reasonably simple approach is to look at return on capital employed.

There are many ways of doing this analysis but the method Ian describes in this paper is relatively straight forward for non analysts or accountants.

The calculation is : EBIT/Assets = Return (%)

EBIT is an excellent measure of profit. It is calculated after depreciation (which Ian Neal sees as part of the true cost of running the business) but before Interest expense and Taxation (thus eliminating financing cost and taxation from the calculation). The Assets part of the calculation is the sum of the assets employed in running the business. Look at the balance sheet carefully to make sure that this is calculated correctly - usually the assets part of this calculation is the sum of fixed assets, receiveables and stock, less accounts payable. Some purists will want to debate this formula, but it is about right.

So what return is adequate? A starting place to answer this question is to look at interest rates. Today cash can be invested into term deposits or bank bills and earn around 7% pa. This is for doing nothing and is risk free. Over the long term investing in a diversified portfolio of shares earns around 10% pa.

One of Ian's ex collegues in the venture capital game used to set his return requirement at multiples of the bond rate- 2x for mature late stage businesses, 3x for small growth businesses 4-5x for start ups with no revenue. Many large corporations use a rule of thumb of 15% as a hurdle rate which new investments must beat in order to be approved.

What return an individual requires is up to them but these are some rules of thumb that may help guide thinking.

The really useful part of this formula however is that it can be broken down into two sub-components and these sub-components can be used to focus attention on which part of the business model requires the most focus to achieve the desired return.

By adding sales into the formula we have a dynamic analysis tool, as the following shows:

(EBIT/ Revenue) X (Revenue/ Assets) = Return

The following worked example to illustrates the value of this analytical tool. Both businesses shown below have the same turnover and one makes 50% of the profit of the other. Which is the best business? Which makes the best return?

Company A earns EBIT/revenue of 20% and has over $500,000 invested whereas Company B earns only 10% EBIT/revenue but has less than $100,000 employed. Return on capital for A is a mere 3.77% and B a more respectable 14%.

What this approach does is allow one to focus on the areas for improvement. A is pretty efficient in its operations as 20% of revenue falls to the bottom line as profit. B is far less efficient as only 10% of its revenue falls to the bottom line in profit. As a start point B might look at operational efficiencies and see if some costs could be saved or more sales generated through the same fixed cost infrastructure using some form of marginal pricing model.

If one looks at assets employed the story is quite different. Given A has roughly $5 invested for each dollar of revenue it generates this has a big drag on return on capital. Is there anything that can be done to reduce that investment? Could land and buildings be sold and leased back, could parts of the manufacturing process be outsourced to a lower cost specialist and the business model be changed to reduce that capital intensity and thus improve return on capital?

In summary, return on capital calculated as shown in this paper is a relatively straight forward way to analyse the financial performance of an enterprise. The calculation can be broken into two sub-components. This allows one to split apart the business and look at assets employed in generating sales and the internal efficiency of the business as measured by EBIT/Revenue. Thus the method helps one focus on those areas which should yield the best returns