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: