The key objective of all business is to optimise the return on capital invested.

Assets are employed to produce products and services that are sold in the market place.

Business owners supply the capital which takes the form of either:

equity (the net worth of the business in the form of accumulated profits or retained earnings that are available for distribution as dividends), or

debt (the net value of loans from the business owners to the company).

Debt may be:

• short-term (current liabilities like overdrafts or repayments due within a year)
• medium-term (to be re-paid in 2-5 years time), or
• long-term.

Together, these are referred to as non-current liabilities.

Capital is used to purchase assets such as plant, equipment and machinery (non-current assets) which are used to convert raw materials and consumables (current assets) into finished products (finished goods stock).

Capital employed in a business consists of owners' equity (including retained earnings) and net non-current liabilities. This is used to finance net non-current assets (like plant and machinery) and working capital to run a business.

Working capital is the difference between current assets and current liabilities.

Business revenue is generated from the sale of goods and services. Part of this revenue is used to pay for the costs of procurement and production (the cost of goods sold).

The difference between sales revenue and the cost of goods sold is the gross profit.

From gross profit, a business meets its indirect expenses. These include insurance premiums, accounting expenses and other general overheads.

Interest expenses are typically deducted from gross profit to arrive at net profit before tax. However, for the purposes of the model used in this tool, interest expenses are not deducted.

The resulting gross profit less expenses (excluding interest) is called Earnings Before Interest and Tax (EBIT).

Working with EBIT focuses purely on the operational side of the business and ignores finance and tax.

Businesses are financed by any combination of equity and debt.

As interest is a tax deductible expense, two businesses with identical operational activity can have different profit outcomes.

This will depend on the financing ratio’s employed. A business financed mainly by debt will have a much lower net profit before tax than one financed by equity.

By using EBIT, we eliminate the impact that financing decisions have on profit. Instead, we focus on operational efficiency.

The profitability ratio = EBIT/sales.

Product profitability is measured by dividing the selling price of a product or service by its cost of manufacture. Its measurement helps management to generate efficiancies to achieve the highest possible price at the least cost.

The asset turnover ratio = sales divided by capital employed

By calculating the number of days it takes to convert working capital into revenue we get a measure of operational efficiency in deployment of assets.

The return on capital employed (ROCE) ratio = EBIT/capital employed

ROCE is another measure of the operational efficiency of a business.

It is simply a ratio of what a business earned before interest and tax (EBIT) and the capital (or net assets) used to earn it.

A business achieves a better ROCE by increasing profitability and/or increasing asset turnover.