The point of a company is to make a surplus, its profit. The reason it borrows or sells shares is to increase that profit. So an important gauge of its success is to see just how well it does it. The point of return on capital employed is that it measures the efficiency with which the company is using its long-term cash. To get this measure, one divides the trading profit (before exceptional items, interest, and tax) by the average capital employed over the period (shareholders’ funds plus borrowings) and multiplies the result by 100. A return of 10 percent is the bare minimum required; 20 percent is pretty good. A low return on capital shows inefficiency in the way it is using the cash, even if the profit margins are high. The first check is to see whether the percentage is higher than the cost of borrowing. It is instructive to compare the return on cash in the business with other things the company (or indeed its investors) might have done with it. A common criterion is to see what it would have yielded if put into something really safe, like gilts. If the return from that sort of investment is at least as great as the company’s, there is something wrong – there should be a ‘risk premium’ for putting the money into something more hazardous such as a business venture. If the yield from gilts is at least 5 percent lower than the return from the company’s use of the money, the investment is beginning to seem reasonable. Investors prefer something better than 7 or 8 percent above the gilt yield.
Return to shareholders
This is another measure that is not derived from the published accounts. It indicates the total performance of an equity over a period such as a year. The figure comes from adding the change in share price (ie the price at the end of the period minus the price at the start), plus the dividends, plus the interest receivable on the dividends, and then taken as a percentage of the price at the start of the period being examined.
