Efficiency ratio - ROCE AO2, AO4
AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest
AO4 You need to be able to Demonstrate a variety of appropriate skills. Command Terms These terms require you to demonstrate the selection and use of subject-specific skills and techniques: Annotate, Calculate, Complete, Construct, Determine, Draw, Identify, Label, Plot, Prepare
A note on the word employ
To employ something is to USE it therefore in this context USE=EMPLOY
All firms use capital to run the business and generate profit. This capital belongs to the owners, the shareholders, and the lenders, primarily the banks. They want to know how well their assets are being used and what return they are achieving on their investment (or capital employed). It should be at least as high as the interest the firm could get from investing in the bank.
Return on capital employed (ROCE)
The management of a firm cannot control the level of taxation or interest rates and so judgment of profit made should be the profit that accrues (comes)from ordinary activities, before taxes and interest are deducted, as this is the value controllable by the management.
Total capital employed is given by the formula:
*shareholders' funds plus long-term liabilities
Be careful about the term capital employed. Some textbooks use this to mean shareholders' funds without long-term liabilities. *The IB uses the formula above.
What is a good ROCE? Certainly, the higher the value of the ratio the better as ROCE measures profitability and no shareholder will complain about too high levels of profit! If the ROCE is less than interest rates in the market it is bad news, as the firm (or shareholder) would have been better advised to leave the money in the bank.
A business could have difficulty servicing (repaying) its borrowings if a low return is being earned for any length of time. So what is an acceptable level? In manufacturing it would be expected that ROCE is in excess of 10% rising to over 25% at the top end. In retail lower figures would be experienced, ranging between 5% and 15%. Most companies would regard 20% as an acceptable level, but like all accounting measures it will depend on a number of factors, such as:
- The industry
- The state of the economy
- The interest rate in the economy (short-term and long-term)
- The size and age of the firm. Established large firms will usually be making a high rate of return.
- The requirements of the firm itself. Here we meet the terms long-termism and short-termism. If you take a short-term view you want high rates of return, the firm want its money back quickly. If they take the opposite approach, they will demand less and be prepared to wait for the profit.
Just like other ratios, ROCE should be examined against previous returns achieved by the business. 20% may be acceptable, but if the firm has a history of achieving over 30%, this would represent a worsening level.
If the ROCE is falling, the firm may address this by:
- Increasing the profit generated by the same level of capital by becoming more efficient
- Maintaining the profits generated, but using less capital
The ROCE is often considered to be a profitability ratio as it measures the efficiency with which the firm generates profit from the funds invested in the business.