Growing a Business That Earns Less Than Its Capital Costs

Stretching supplier terms raises the ratio without improving anything

Current liabilities are subtracted because trade credit finances part of the business at no charge, so it is not capital anyone had to provide. That makes the denominator movable: push current liabilities from 5 million to 8 million by paying suppliers later and capital employed falls to 17 million, lifting the return from 25 % to 29.4 % with no change to profit, sales or costs. The improvement is real in the sense that less of the owners' money is tied up, and hollow in the sense that it was taken from suppliers rather than earned. Read a jump in this ratio by checking whether the numerator or the denominator moved, and if it was the denominator, which line of it.

A high return can be a sign of nothing being invested

Capital employed includes assets at their written-down value, and a company that has stopped replacing its equipment sees that value fall year after year while profit holds steady. The return therefore climbs, and it climbs fastest in the last years before something has to be replaced all at once. A rising ratio driven by a shrinking denominator looks identical on a chart to one driven by a rising numerator, and only the capital expenditure line separates them. Where the ratio is used as a target, this is the failure mode to watch: the cheapest way to hit it is to defer the investment that keeps the business working.

Frequently asked questions

Where does the cost of capital come from?

It is a weighted blend of what the debt costs after tax and what the shareholders expect, in proportion to how much of each finances the business. The debt half is observable — it is on the loan agreements. The equity half is an estimate, usually built from a risk-free rate plus a premium for the risk of this particular business, and reasonable people produce estimates several points apart. That uncertainty is why the spread matters more than the exact number: a seventeen-point gap survives any plausible disagreement about the cost of capital, while a two-point gap does not survive rounding.

Opening capital employed or the average?

The average of the two ends, for the same reason as any ratio that divides a year by a balance: the profit was earned across twelve months while the closing balance sheet reflects only the last day. It matters most when the capital base moved a lot — an acquisition, a large disposal, a factory completed in the autumn — which is exactly when the ratio is being examined. Where the year contained such an event, report the ratio both ways and say which one the conclusion rests on.