Capital efficiency is a measure that estimates how efficiently the capital is deployed.
Why is capital efficiency useful?
Investment in a venture, business, or project comes with the expectation of gaining more returns than the initial investment. However, not all ventures generate returns at the same rate. Some generate better-than-expected returns, and some generate lower-than-expected returns.
Capital efficiency allows dollar returns for every dollar invested to be measured. It can therefore be used as an indicator of a company’s profitability levels.
It can also be used to determine how efficiently capital is employed by the company to generate returns. It can be tested using two metrics: earnings before interest and taxes (EBIT) and return on capital employed (ROCE). These metrics are used to compare the profitability of two companies or projects.
EBIT, also known as operating income, can be calculated by subtracting the cost of goods sold and operating expenses from revenue. Since interest expenses and taxes do not form a part of EBIT calculation, it’s used to compare the earnings of comparative businesses. The formula is:
EBIT= revenue - cost of goods sold - operating expenses
The capital employed to generate the earnings is not captured in EBIT. It can only be used to compare the profitability between two companies.
Using capital employed in conjunction with EBIT shows how efficiently the capital is utilized to generate earnings. ROCE captures the capital efficiency of a project or venture. ROCE is the ratio between EBIT and capital employed. The formula is:
Here, the capital employed is calculated as the difference between total assets and current liabilities.
Capital employed = total assets - current liabilities
ROCE captures the return generated for every dollar spent. A company can have a higher ROCE with a lower EBIT compared to another company if the capital employed is smaller.
Take a look at the example of the two companies below:
Company A generates an EBIT of $500,000 by employing a mere $2M. Company B generates six times the EBIT at $3M. But the capital employed by company B is substantially higher. This results in a ROCE of 25% for company A and 20% for company B. Company A is utilizing the capital more efficiently than company B. As an investment choice, company A is much more preferable than company B.
When capital-intensive projects are undertaken, they do not generate a return immediately. It takes time to scale the operations and generate returns. The capital efficiency should be measured at regular intervals of the project. If the project is not generating expected returns compared to the capital employed, it’s better to scrap the project if there are better investment avenues (that is, one with higher capital efficiency) available.