Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons for change in the ratios for two years. Assume opening stock of ₹10,000 for the year 2021-22. Ignore taxation.

Justification for Using End-of-Year Capital

Using capital employed at the end of the year for ratio calculations is preferred for several reasons:

• Reflects Actual Investment: The end-of-year capital figure represents the actual amount of capital available for generating profits throughout the year. Capital may have been added or withdrawn during the year, and the end-of-year figure provides a more accurate average investment.
• Matching Principle: It aligns with the matching principle in accounting, which dictates that expenses should be matched with the revenues they generate. End-of-year capital is more closely associated with the year’s earnings.
• Consistency: Using a consistent time frame (end of the year) for both capital and profit allows for meaningful comparisons across different periods and companies.

Hypothetical Scenario and Ratio Analysis

Let's assume the following data for two years (2021-22 and 2022-23):

Particulars	2021-22 (₹)	2022-23 (₹)
Opening Stock	10,000	15,000
Closing Stock	15,000	20,000
Revenue	100,000	120,000
Cost of Goods Sold (COGS)	70,000	85,000
Operating Expenses	15,000	18,000
Capital Employed (End of Year)	50,000	60,000

We will calculate Return on Capital Employed (ROCE) as an example:

ROCE = Earnings Before Interest and Taxes (EBIT) / Capital Employed

Year 2021-22

EBIT = Revenue - COGS - Operating Expenses = 100,000 - 70,000 - 15,000 = 15,000

ROCE = 15,000 / 50,000 = 0.3 or 30%

Year 2022-23

EBIT = Revenue - COGS - Operating Expenses = 120,000 - 85,000 - 18,000 = 17,000

ROCE = 17,000 / 60,000 = 0.283 or 28.3%

Reasons for Change in ROCE (2021-22 to 2022-23)

Despite an increase in both revenue and EBIT, the ROCE decreased from 30% to 28.3%. This can be attributed to the following factors:

• Higher Capital Employed: The capital employed increased from ₹50,000 to ₹60,000. This means the company invested more capital to generate the increased revenue and profit. Since the increase in capital was proportionally higher than the increase in EBIT, the ROCE declined.
• Increased Cost of Goods Sold: While revenue increased, the COGS increased at a faster rate. This could be due to rising raw material costs, inefficiencies in production, or changes in product mix.
• Increased Operating Expenses: Operating expenses also increased, contributing to a lower overall profitability margin.
• Inventory Management: The increase in closing stock from ₹15,000 to ₹20,000 suggests potential issues with inventory turnover. Higher inventory levels tie up capital and can indicate slower sales.

A detailed analysis would require further investigation into the specific reasons behind the changes in COGS, operating expenses, and inventory levels. For example, a rising COGS might necessitate a review of supplier contracts or production processes.