Return on Capital Employed & Return on Investment (AQA A Level Business): Revision Note

Return on capital employed in context

• RoCE measures how efficiently a business generates profit from the long-term capital invested in it

  • It is widely regarded as one of the most important indicators of overall financial performance

• A return on capital employed (RoCE) of 15% is neither impressive nor disappointing until it is assessed against

  • What the business was trying to achieve

  • How rivals are performing

  • What was planned

  • The broader environment the business is operating in

RoCE relative to objectives

• A business's RoCE target should reflect its strategic ambitions and the expectations of its investors

  • If a company has set an objective of achieving a RoCE of 18% and delivers 15%, that represents an adverse variance, even if 15% is above the industry average

  • Conversely, a business that targeted 12% and achieved 15% has outperformed its own goals, regardless of how that figure compares to rivals' performance

RoCE relative to competitors

• A business generating a RoCE significantly above the sector average is creating more value from the same level of investment

  • This is a clear competitive advantage

• However, comparisons must account for differences in capital intensity

  • Capital-intensive industries (manufacturing, property, utilities) typically produce lower RoCE figures than asset-light businesses (software, consulting, marketing agencies)

    • This is simply because they require far more capital to generate each pound of profit

  • E.g. a RoCE of 10% may represent excellent performance in a capital-heavy sector and be deeply disappointing in a labour-intensive business

RoCE relative to business planning

• RoCE should be measured against the business's own budget and compared over time to assess whether capital is being used more or less effectively

  • If RoCE is falling over time despite growing profits, it may indicate that capital employed is growing faster than operating profit

    • This may be due to acquisitions, new sites opening or investment in assets that have not yet generated a return

  • If RoCE is rising, the business is generating proportionally more profit from the same amount of capital

    • This is often a sign of improving efficiency

Example

Vantage Packaging's RoCE moved from 11% three years ago, to 13% two years ago, to 16% this year.

The improving trend suggests the business is deploying its capital with increasing effectiveness.

This is a reassuring signal for investors and lenders even if the current figure is not exceptional.

RoCE and the business context

Example

Helios Travel invested £1.5 million in a new call centre facility eighteen months ago. RoCE fell from 22% to 17% in the year the investment was made, a drop that concerned some shareholders.

However, in the context of a major capital investment that had not yet reached full operational capacity, the fall was anticipated and planned for.

The subsequent recovery to 21% suggests the investment is beginning to generate returns as expected.

Return on investment in context

• Return on investment (RoI) evaluates the financial return generated by a specific investment decision, such as a piece of equipment, a marketing campaign or the opening of a new location

  • It answers the question: was this particular investment worth making?

RoI relative to objectives

• Before an investment is made, a business will typically set a minimum acceptable RoI

  • This is a threshold below which the investment would not be considered worthwhile

• Assessing RoI in context means checking whether the actual return has met, exceeded or fallen short of that threshold

RoI relative to competitors

• Comparing RoI against competitors helps a business understand whether its investments are generating returns in line with industry norms

  • If rivals are consistently generating higher RoI from similar investments, it may indicate that the business is paying too much for its assets, operating them less efficiently or choosing lower-value investment opportunities

• Where competitors' internal RoI data is not publicly available, the business can instead compare RoI against external benchmarks

  • For example, the return available from leaving capital in a savings account

Example

CarFlex Ltd's RoI of 10% on its robotic production line is below its own target.

However, comparable businesses in the sector are generating RoI of 7–9% on similar investments.

CarFlex's result, while disappointing against its internal goal, is still competitive relative to the market.

RoI relative to business planning

• Comparing actual RoI against the forecasted returns reveals whether the investment has performed as planned

  • If not, what has caused the variance?

• A lower-than-forecast RoI may reflect overoptimistic forecasts, unexpected costs or a longer-than-expected period before the investment reaches full productivity

• A higher-than-forecast RoI may indicate that the original projections were too conservative, or that market conditions have been more favourable than expected

Example

Chrysalis Design's managers forecast an annual additional profit of £130,000 from its investment in new software.

Actual additional profit in year one was £110,000 — an adverse variance of £20,000.

Investigation reveals that the software took three months longer than expected to reach full capacity due to staff training delays, reducing the effective operating period in year one.

Managers now expect the original forecast to be met from year two onwards.

RoI and the business context

• RoI must be assessed in light of the circumstances surrounding the investment

Time

• Some investments take years to generate their full return

• A low RoI in the early years of a long-term investment does not necessarily mean the decision was wrong

Non-financial benefits

• An investment may generate returns that cannot be captured in an RoI calculation

  • Benefits could include improved product quality, better staff conditions reduced environmental impact or a stronger brand

Risk

• A higher RoI target is generally expected from riskier investments

  • A RoI of 15% on a well-established, low-risk process improvement is arguably more valuable than the same return from a speculative new product launch

Opportunity cost

• Whether it is the best available use of the capital

  • A RoI of 10% may be acceptable — or it may mean the business has missed a better opportunity elsewhere