There are dozens of ratios that could be used to analyze the performance of a business. Return on Capital Employed (ROCE) is a fundamental ratio which is used to monitor business performance. It measures the amount of profit earned as a percentage of capital employed that is it helps to provide the answer to the question that we were considering when evaluating the performance of business profitability: “Is the profit sufficient considering the amount of capital invested to earn that profit?“ In this post we will look at how to figure and analyze Return On Capital Employed (ROCE).
Common Size Statements
Approach that I found useful when I am at the early stages of analyzing a company’s financial statements is to prepare a “common size statement“. This is a statement which simply expresses each figure within the income statement or balance sheet as a percentage of a total.
When you are looking at the results for more than one year, a common size statement can sometimes help you to identify the major changes that have occurred between the two years. It is usually possible to get a general feel for the changes by looking at the absolute figures but a common size statement can help to really focus your attention on the major changes that might be worthy of further analysis.
To begin the preparation of two common size balance sheets for Lie Dharma Putra LLC we need to know the value of the total assets at the end of each of the two years. The total asset value is the sum of the balance sheet value of the non-current assets and the current assets. Therefore the total asset value at the end of Year 2 is $92 m (52 + 40) and at the end of Year 3 is $145 m (85 + 60).
Beginning with Year 2, the non-current asset balance as a percentage of the total assets of $92 m is 56.5 per cent (52/92 x 100%). Performing the same calculation for each figure on the balance sheet, that is expressing it as a percentage of $92 m, produces the following results.
Lie Dharma Putra LLC Common size balance sheets as at 31 December:
What information can we obtain from these common size statements?
The common size statements assist our initial analysis by helping us to see the significance of the major changes that have occurred between the two years.
- Although the absolute amount of money invested in non-current assets has increased (from $52 m to $85 m), the percentage of total assets represented by non-current assets has increased by only just over 2 per cent, (from 56.5 per cent to 58.6 per cent).
- There is a significant increase in the proportion of the investment in total assets which is tied up in receivables. This has increased from 19.6 per cent to 27.6 per cent.
- This increase in receivables has been partly funded by a significant increase in trade payables, from 11.1 per cent to 19.3 per cent.
- Only 2.8 per cent of total assets is represented by the bank balance in Year 3, compared with 10.9 per cent in Year 2.
- 13.8 per cent of the company’s assets are financed by external investors (loan capital) in Year 3.
What is the potential impact of this?
In conclusion, the common size statement has signalled that we might need to pay particular attention to the company’s control of its receivables, its liquidity and the impact of the new reliance on external long-term funding.
Steps To Take To Figure Return On Capital Employed (ROCE)
The return on capital employed (ROCE) is calculated as follows:
ROCE = [Profit before interest and taxation / (Share capital + reserves + long-term loans)] x 100%
The profit figure is usually taken before interest because this is the profit that has been earned to pay all the providers of finance, that is the profit on the top of the calculation ‘belongs’ to the providers of finance on the bottom of the calculation.
Some analysts argue that profit before interest and tax (operating profit) is the most appropriate measure of an organization’s performance because it is the profit over which operational managers can exercise day-to-day control: they have some influence over this profit measure.
If we chose profit after interest the performance would be distorted by the way in which the organization is financed, that is by how much interest has to be paid. Operational managers have no direct influence over this. If we used the profit after taxation the performance would be distorted by the vagaries of the taxation charge, which again is outside the control of operational managers.
Using Lie Dharma Putra LLC Common size Balance Sheet:
The ROCE for Lie Dharma Putra LLC for Year 2 is : 12/72 x 100% = 16.7%
What is ROCE of Year 3? Using the same formula:
ROCE for Year 3 = 26/100 x 100% = 26%
So, what did we see?
The ROCE has improved dramatically. So now we need to start to look at why this has happened. We are going to perform a sub-analysis of the ROCE, that is break it down into its constituent parts.
4 Basic Steps To Improve ROCE [The Constituent Parts of ROCE]
Returning for a moment to the example of a small newsagent’s shop, suppose that you wanted to improve the shop’s ROCE.
What basic steps could you take to try to achieve an improvement?
Here are four basic steps that you could take to improve the ROCE of a newsagent’s shop:
Step-1: Put the prices up (assuming that this does not adversely affect sales volume)
Step-2: Reduce costs
Step-3: Sell more newspapers, etc.
Step-4: Reduce the amount of capital employed
Steps 1 and 2: They can effectively be combined into one simple statement: “EARN MORE PROFIT FROM EACH SALE THAT IS MADE!” . This aspect of profitability is monitored by the operating profit margin. This ratio relates the operating profit to the sales value:
Operating profit margin = [Profit before interest and taxation x 100%] / Revenue
Remember that we are trying to perform a sub-analysis of the ROCE. Therefore we must use the same profit measure that we used in the ROCE calculation.
Steps 3 and 4: They could be stated in general terms as: “GENERATE MORE SALES PER $1 OF CAPITAL INVESTED!“. This aspect of performance is measured by the asset turnover ratio, which monitors the level of sales revenue relative to capital employed:
Asset turnover = Revenue / [Share capital + reserves + long-term loans]
Remember again that we are still performing a sub-analysis of the ROCE. Therefore the figure for the capital employed (the denominator) must be the same as in the ROCE calculation.
Now we can put all this together to see the constituent parts of ROCE:
ROCE = operating profit margin x asset turnover
ROCE = Profit before interest and taxation / Capital employed
ROCE = [Profit before interest and taxation / Revenue ] x [Revenue / Capital employed]
Note: You should be able to see that when the formula for operating profit margin and asset turnover are multiplied together, the revenue on the top and bottom of the calculation washed out, leaving the basic formula for the ROCE.
Therefore, when we want to explore the reasons for changes in the Return On Capital Employed (ROCE), we can break it down between the profitability of sales (the operating profit margin) and the level of sales revenue achieved from the assets (the asset turnover).