Blog #07 - Return On Capital Employed

 

Return On Capital Employed

 

In Blog – 04 we learnt about Return on equity in this blog we will see Return On Capital Employed. Return on equity, as we saw, deals with the profit on the capital employed by investors or owners but contributed amount by them is not sufficient. There are also some capitals which includes debt, loans, liabilities etc. Now we want to see the profit made on complete capital which includes amount contributed by owners/investors along with debt, loans and other liabilities. RoCE is basically Return on Total Capital.

 

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We know that

Assets = Equity Share Capital + Reserves & Surplus + Preferred equity + Current liabilities + Non Current liabilities. Equation in green represents equity while equation in red shows liabilities. Read Blog #04 for in-depth understandings. Here we will discuss only liabilities, so liabilities are divided into two parts namely current liabilities and non-current liabilities.  Current liabilities are short term liabilities while non-current liabilities are long term or greater than one year. Current liability is further divided into four categories – short term debt, trade payables, advances, over dues and other short term liabilities on the other hand long term liabilities covers long term debt, deferred tax liability and other long term liabilities. Let understand by an example. 

 

 

Suppose the income statement of a company is as follow.

EBIT             8000000

Interest         2000000

Tax@30%      1800000

PAT              4200000

By definition ROCE = Profit/Capital Employed. 

 

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Now the question arises what will the profit in this case? As we saw in Blog #04 we have to look for the priority or how the money flows. First of all you have to pay for short term and long term debt i.e. interest will be paid first then we getting PBT or Profit Before Tax. After that on second number govt. will took tax @30% and then you will get PAT or Profit After Tax.  After this you will pay for preferred equity shareholders and last payment will account for Equity share capital (in this example). While calculating ROE or Return on Equity in Blog #04, we took PAT instead of profit in definition to calculate ROE. Now in this case i.e. in calculation of ROCE, our capital was capital by investors/owners plus liabilities then we have to drop interest and tax in our definition logically. So here ROCE will be defined as the ratio of EBIT (earnings before interest & tax) to the capital employed (total capital). Or ROCE = EBIT/Capital Employed.

 

 

Now again the question arises what we will take instead of capital employed. The question is little bit complex. The Capital Employed in calculation of RoCE varies with the analysts. If you search on the internet you will get different RoCE for a same company for the same period of time. Our equity will be fixed. Some analysts use capital employed as sum of equity and non-current liabilities because according to them short term liabilities doesn’t affect company’s performance while some analysts take capital employed as sum of equity and long term debt and some analysts take capital employed as sum of long term debt, short term debt and equity. As per me third one is the best definition for capital employed because as per me deferred tax liabilities and other non-current liability may not be given by banks, it may be from other source that’s why it is not fair to include them. It is my opinion to use capital employed as sum of long term debt, short term debt and equity. Rest is your choice.

RoCE

 

Suppose our equity is 200 lakhs and short term debt is 50 lakhs while long term debt is 150 lakhs. So by definition (third one), in our example, ROCE = 80 lakhs (EBIT) / (200 lakhs + 200 lakhs) which is equal to 20%. Now by second definition RoCE will be 80 lakhs/350 lakhs which is equal to 22.86%. Similarly you will get different RoCE by first one. Now the question is which formula should be taken.

 

 

Look, it doesn’t matter which formula you will use to calculate. We have to compare companies practically. All of the formulas are right in their places. But we have to take only one formula to calculate RoCE for two or multiple companies. Don’t use different approach for two companies. Now I think RoCE is cleared to you. Let go to some important points in RoCE.

 

Why Do We Calculate RoCE?

RoE doesn’t give overall picture of returns on capital and it can be manipulated as we saw in blog 4. RoCE is mainly calculated because it gives overall returns on the total capital employed in the business also it can compared to returns from other investments like FD, MF, Bonds etc.

Invest only if RoCE > Cost of Capital. Suppose if interest rate is 12% then ROCE should be greater than 12%. Practically RoCE>WACC (weighted average cost of capital – will be discussed in other blog) 

 

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