Return on capital employed (ROCE) is often seen by many as a key success indicator for a business. The theory is that management has been entrusted with the net assets of the business, with a duty to make a profit from them. It helps to assess how efficiently a business employs all its available capital in generating profits.
ROCE is calculated as ROCE = Earnings Before Interest and Taxation/Capital Employed and shows you the amount of profit a company is generating per £1 of capital employed in the business. The more profit per £1 a company can generate, the better. Thus, a higher ROCE indicates stronger profitability across the company and can be used as a comparison company to company or year on year.
Unlike Return on Equity (ROE), ROCE gives an idea as to how well the company is using all of its funding to generate profits.
How can it be improved?
Looking at the formula (ROCE = EBIT/CE) it’s simple, we either increase EBIT or reduce CE. However, in practice, it is slightly more difficult.
Let’s take a closer look …
Earnings before Interest and Taxes (EBIT)
Starting with EBIT, the higher the revenue and the lower the costs, the better the ROCE. In many businesses, staff or wages are the biggest cost, so it would be tempting to reduce these. This can be achieved by a reduction in the headcount or by lowering the rate of pay. This would, in effect, increase ROCE in the short term. But is it the ideal solution?
It is this thinking that has contributed to the poor productivity levels seen in many UK businesses. Most companies say their staff are a key asset but are seen by management as a cost, and by reducing these costs they will build a stronger and more profitable business. In many hierarchical businesses, staff are recruited, managed and appraised on the hours they work and this has the effect of making staff work longer and not necessarily more efficiently.
Good managers see things differently. They do consider employees as an asset. In accounting terms, assets are company resources which have future economic value. Instead of seeing employees as a problem, these managers see them as a valuable resource. They know that people have the capability to grow sales, satisfy customers, improve processes, innovate products, and do countless other things that add money to both the top and bottom line which in return will increase the ROCE.
Capital Employed (CE)
Turning now to Capital Employed. Paying off debt will reduce liabilities and in turn increase the ROCE as will restructuring the existing debt or refinancing at lower interest rates or better repayment terms.
A key area is to improve the management of working capital. Better inventory management and credit control can often be very effective in improving a company’s overall financial performance. Proper monitoring, organisation and coordination of cash tied up in working capital can significantly improve a company’s cash flow. By focusing on this area the ‘released cash’ can be reinvested into the company which will enable it to grow and increase its market base.
Many businesses accumulate unnecessary assets that are no longer needed. They have, what I call, a ‘lazy balance sheet’. You don’t make profits by owning assets. You make profits by using them.
So, cleaning up your ‘lazy balance sheet’ is vital – reducing excess plant and equipment, receivables and inventory will all improve business performance which will improve your ROCE.
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