Return On Capital Employed
Discussion
I'll admit to not being the most clued up when it comes to Financial Accounting. I'm currently studying towards a purchasing qualification through distance learning and there is some basic financial accounting theory in one of the modules. The ROCE ratio doesn't quite make sense to me as it is described in the textbook and wondered if any experts on here could clear it up.
The book says that average capital employed is calculated by averaging the capital employed in the opening and closing balance sheets. See photo below - (158 + 151)/2 = 154.5
It goes on to say the average capital employed includes long term finance but does not include short term finance such as bank overdrafts.
So the textbook works ROCE out as:
27 million (Operating profit) divided by 154.5 (average capital employed) times by 100 = 17.5%
My question is, why does the 40 million long term loan not come in to play? As the book states that average capital employed includes long term finance, should the 40 million be added to the 154.5 million? This would give an ROCE of 13.9%
The book says that average capital employed is calculated by averaging the capital employed in the opening and closing balance sheets. See photo below - (158 + 151)/2 = 154.5
It goes on to say the average capital employed includes long term finance but does not include short term finance such as bank overdrafts.
So the textbook works ROCE out as:
27 million (Operating profit) divided by 154.5 (average capital employed) times by 100 = 17.5%
My question is, why does the 40 million long term loan not come in to play? As the book states that average capital employed includes long term finance, should the 40 million be added to the 154.5 million? This would give an ROCE of 13.9%
The ROCE ratio is calculating the returns that you have achieved on your own funds. The term loan is money that you have borrowed from a third party, not your own. The term loan doesn't share in the proceeds of the business beyond its fixed interest rate.
The reason short term borrowings or current assets / liabilities are treated differently is because they are just working capital, i.e. a timing effect between your suppliers and customers and should net out to zero in the long run.
The reason short term borrowings or current assets / liabilities are treated differently is because they are just working capital, i.e. a timing effect between your suppliers and customers and should net out to zero in the long run.
I would include the Long Term Liabilities.
I would divide PBIT over (Shareholders Funds AND Long Term Liabilities) x 100%
I would then recalculate as an aside ADDING BACK IN DIVIDENDS to PBIT to reduce it as in our business we use them in lieu of salary.
Our ROCE in 1991 was 21.27%. Last year it was 53.69%. However, once Dividends were added back in it was a much more realistic 15.52%.
I get 17.09% on your example.
I would divide PBIT over (Shareholders Funds AND Long Term Liabilities) x 100%
I would then recalculate as an aside ADDING BACK IN DIVIDENDS to PBIT to reduce it as in our business we use them in lieu of salary.
Our ROCE in 1991 was 21.27%. Last year it was 53.69%. However, once Dividends were added back in it was a much more realistic 15.52%.
I get 17.09% on your example.
Edited by Jockman on Friday 24th February 21:25
NickCQ said:
The ROCE ratio is calculating the returns that you have achieved on your own funds. The term loan is money that you have borrowed from a third party, not your own. The term loan doesn't share in the proceeds of the business beyond its fixed interest rate.
The reason short term borrowings or current assets / liabilities are treated differently is because they are just working capital, i.e. a timing effect between your suppliers and customers and should net out to zero in the long run.
This suggests differently:The reason short term borrowings or current assets / liabilities are treated differently is because they are just working capital, i.e. a timing effect between your suppliers and customers and should net out to zero in the long run.
http://lexicon.ft.com/Term?term=return-on-capital-...
Juanco20 said:
NickCQ said:
The ROCE ratio is calculating the returns that you have achieved on your own funds. The term loan is money that you have borrowed from a third party, not your own. The term loan doesn't share in the proceeds of the business beyond its fixed interest rate.
The reason short term borrowings or current assets / liabilities are treated differently is because they are just working capital, i.e. a timing effect between your suppliers and customers and should net out to zero in the long run.
This suggests differently:The reason short term borrowings or current assets / liabilities are treated differently is because they are just working capital, i.e. a timing effect between your suppliers and customers and should net out to zero in the long run.
http://lexicon.ft.com/Term?term=return-on-capital-...
In my industry (banking) I would always consider 'capital' to be synonymous with equity. The important ratio for shareholders is how much profit you generated as a percentage of the money that they gave you.
NickCQ said:
I stand corrected, and surprised!
In my industry (banking) I would always consider 'capital' to be synonymous with equity. The important ratio for shareholders is how much profit you generated as a percentage of the money that they gave you.
I agree and this is why I'm getting confused. There seems to be plenty of conflicting information out there about how to calculate this ratio In my industry (banking) I would always consider 'capital' to be synonymous with equity. The important ratio for shareholders is how much profit you generated as a percentage of the money that they gave you.
Juanco20 said:
I agree and this is why I'm getting confused. There seems to be plenty of conflicting information out there about how to calculate this ratio
I don't even use an average. I just use the figure for that year only.An important part of ratio analysis is that you are consistent in the calculations you use, even though there are various methods available (especially in Gearing !!)
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