Capital Efficiency Measures in Industrial Business—It Is Time to Critically Review These Calculations

• Date: 01 March 2017
• DOI: http://doi.org/10.1002/jcaf.22262
• Published date: 01 March 2017

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© 2017 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22262

Capital Efficiency Measures

in Industrial Business—It Is Time to

Critically Review These Calculations

Alexander Carl Baumast

The concept of

measuring sus-

tainable share-

holder value by use

of calculations like

residual income, eco-

nomic value added

(EVA),1- return on

capital employed

(ROCE), and others

is a widely discussed

topic over the past

30years. Although

there are still fun-

damental concerns

regarding the useful-

ness of such mea-

sures, many, if not

most, of the big blue-

chip companies have

introduced capital

efficiency measures

both for internal

incentive schemes and for

external reporting purposes.2

The common objective of

these concepts is to avoid man-

agement gaining short-term

benefits by manipulating what

are considered to be more easily

influenceable reporting numbers

like earnings before interest and

tax (EBIT), cash flow, earnings

per share, and so on. Incontrast,

capital efficiency measures are

intended to deliver more reliable

information about (or would at

least provide complementary but

valuable insight in) the long-term

and sustainable prof-

itability of a company

and therefore deliver

a deeper insight into a

companies’ ability to

generate sustainable

shareholder value.

While this article

will not challenge the

usefulness and value

of capital efficiency

measures, it is with-

out any doubt that a

prudent management

of capital in all areas

(including invest-

ment in assets, pay-

ment management,

etc.) is essential for

the long-term success

of a company.

Nonetheless, it is

the case that the cal-

culation of various capital effi-

ciency measures, which is com-

monly used, opens the door

for management to influence

and artificially improve these

numbers without achieving the

desired benefit for the company

and its stakeholders.

Capital efficiency measures like economic value

added (EVA) and return on capital employed

(ROCE) have been developed and are regularly

used by many industrial companies to avoid short-

term bias and provide stakeholders with valuable

insight into the long-term ability of a company to

create value. In recent years, new models have

emerged (partly promoted by the financial indus-

try), which in turn attract management teams to

optimize those capital efficiency figures without

appropriately considering both underlying risk and

long-term benefit for the companies’ stakehold-

ers. This article highlights examples where this

is practiced by shifting of financing sources in

order to achieve an artificial improvement of those

figures. It also provides suggestions to avoid such

misleading results in the future.

© 2017 Wiley Periodicals, Inc.

Editorial Review