Rate of Return - Return on Capital Employed Ratio

The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the investments the shareholders have made in their company. Think of it this way: if we had a savings account with a bank and we'd been paid, say, £25 interest at the end of a year; and we had saved £500, we could work out the rate of interest we had earned:

Rate of interest

=

Interest earned

* 100

=

25

* 100

=

1

* 100

=

100

= 5%

Amount saved

500

20

20

So, we have earned 5% interest on our savings.

Imagine now that instead of talking about a savings account, we were talking about a company and the profit for the year and its capital employed had been £25 and £500 respectively then the ROCE for that company would be 5% too.

ROCE

=

Profit for the Year

* 100

=

25

* 100

=

1

* 100

=

100

= 5%

Equity Shareholders' Funds

500

20

20

Did you notice that we use the Equity Shareholders' Funds instead of Capital Employed? In fact, they are different names for the same thing! We could call the ratio the Return on Shareholders' Funds (ROSF) just as easily if we wanted; but generations of accountants and students only know it as ROCE.

In accounting, there can be different definitions of what certain terms mean. The use of the term 'capital employed' can mean different things. It can, for example, include bank loans and overdrafts since these are funds employed within the firm. Because there are different interpretations of what ROCE can mean, it is suggested that you use a method which you feel comfortable with but be aware that others may interpret your definition in a different way. Below is a guide to some of the interpretations that we have found on this issue.

Source and/or Definition of Return	Definition of Capital Employed
Elliott & Elliott: ROCE = Net profit/capital employed	Capital employed = total assets
Investor Words:	Capital employed = fixed assets + current assets - current liabilities
investopedia.com: Return = Profit before tax + interest paid	Capital employed = ordinary share capital + reserves + preference share capital + minority interest + provisions + total borrowings - intangible assets
Holmes & Sugden: Return = trading profit plus income from investment and company share of the profit of associates	TRADING capital employed = share capital + reserves + all borrowings including lease obligations, overdraft, minority interest, provisions, associates and investments
	OVERALL capital employed = share capital + reserves + all borrowings including lease obligations, overdraft, minority interest, provisions
DTI	Capital employed = total fixed assets + current assets - (current liabilities + long term liabilities + provisions)
Johnson Matthey Annual Report & Accounts	Capital employed = fixed assets + current assets - (creditors + provisions)

Let's calculate the ROCE for the Carphone Warehouse now; and here are the figures we need:

Carphone Warehouse	31 March 2001	25 March 2000
	£'000	£'000
Profit for the financial period	38,159	16,327
Equity shareholders' funds	436,758	44,190

Off you go!

Did you get this?

What do we think of these results? Well, the question we have to ask is

"Could we have earned more money (profit) if we had invested in a different business or simply put our money in the bank?"

Well, interest rates at the bank were somewhere around 4 or 5% in 2001 so we did better than that; but there are many businesses that have a ROCE of higher than 8 or 9%. Still, in 2000 the Carphone Warehouse had an ROCE of almost 37%: that's very good by all standards.

So what went wrong between 2000 and 2001? What happened, it didn't necessarily go wrong, was that the capital employed increased from £44,190,000 to £436,758,000 (a 10 fold increase) BUT the profits increased from £16,327 to only £38,159... they only just about doubled.

It's no surprise then that the ROCE fell so sharply as capital employed increased 5 times faster than the profit did.

It will be interesting to see what 2002 brings for the Carphone Warehouse and their ROCE.

We will look at Vodafone's ROCE shortly, but for interest here are some other ROCE values to compare with the Carphone Warehouse:

	Leisure & Hotels	International Airline	Manufacturer	Retailer	Discount Airline	Refining	Pizza Restaurants	Accounting Software
ROCE	5.56%	3.16%	-12.12%	-0.12%	33.63%	16.17%	16.14%	16.29%

Again, these other ROCE values demonstrate that not everyone can get the same results for the same ratio at the same time: it depends on the industry, the management, the economy and so on.

The ROCE results in this new table relate to the Carphone Warehouse's results for the year ended 25 March 2000 of 36.95%. This is a good result as it shows that the business is effectively earning around 37% on the (investment) funds that the shareholders have invested in it.

Contrast the other ROCE values with the Carphone Warehouse and we can see that only the discount airline has a ROCE value anywhere near it. The international airline's ROCE is extremely low at just over 3%. Wouldn't the shareholders be better off selling the business and putting the money in the bank as it would earn more than that?

We should also compare these ROCE values with the profitability values. Let's just compare net profitability with the ROCE.

	Leisure & Hotels	International Airline	Manufacturer	Retailer	Discount Airline	Refining	Pizza Restaurants	Accounting Software
Net Profit	7.36%	4.05%	-10.48%	1.63%	10.87%	12.63%	7.55%	27.15%
ROCE	5.56%	3.16%	-12.12%	-0.12%	33.63%	16.17%	16.14%	16.29%

Putting the data from this table on a graph can help us to see if there is a relationship between them:

There does seem to be a relationship between the net profit margin and the ROCE: the higher the net profit margin, the higher the ROCE. After all, the curve on this graph is not a straight line and it might even be a true curve meaning that the relationship is more complex than we might think. Keep an eye on this relationship whenever you assess the profitability of a business.

Source:
http://www.bized.co.uk/