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Friday, April 30, 2010

Accounting Ratio Analysis

Return on Capital Employed (ROCE)

It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed.

ROCE = Profit on ordinary activities before interest and taxation / Capital employed

Capital employed = shareholders’ funds plus creditors: amounts falling due after more than one year’ plus any long term provisions for liabilities and charges

The underlying principle is that we must compare like with like, and so if capital means share capital and reserves plus long term liabilities and debt capital, profit must mean the profit earned by all this capital together. This is profit before interest and taxation (PBIT), since interest is the return for loan capital.

What does a company’s ROCE tell us? What should we be looking for? There are three comparisons that can be made.
  • The change in ROCE from one year to the next can be examined
  • The ROCE being earned by other companies, if this information is available, can be compared with the ROCE of this company.
  • A comparison of the ROCE with current market borrowing rates may be made.
    1. What would be the cost of extra borrowing to the company if it needed more loans, and it is earning a ROCE that suggests it could make profits to make such borrowing worthwhile? 2. Is the company making a ROCE which suggests that it is getting value for money from its current borrowing?
    3. Companies are in a risk business and commercial borrowing rates are a good independent yardstick against which company performance can be judged.

However, it is easier to spot a low ROCE, than a high one, because there is always a chance that the company’s fixed assets, especially property, is undervalued in its balance sheet, and so the capital employed figure might be unrealistically low.


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