Return on Capital Employed

Assume that a genie appears before you for some bizarre reason. And he wishes to grant you a boon -- just one financial ratio as a valuation tool. What would you ask for?

 

Would it not be the ratio that will help you figure out in one go general management performance in relation to the capital invested in the business? Well, what you would be asking for is good old Return on Capital Employed!

While valuing companies, we are actually trying to measure the return that the company is able to generate. Those companies that earn a higher return on every rupee that is invested are more valuable than those who earn a lower return on a similar investment.

Two very popular tools that come in handy in studying returns generated by companies are:

1. Return on Net Worth, defined as Net Profit/Net Worth.
2. Return on Capital Employed, defined as Operating Profit less Depreciation/(Net Worth + Debt - Non Interest Bearing Debt).

The next question that presents itself is: How are they different? And, more importantly, which is a better measure of return?

Well, let us hear the sales pitch of both of them.

 

Enter Return on Net Worth

We have met Return on Net Worth before. In all its simplicity it tells us what, as shareholders, we are getting back from our investment in the business. And as a shareholder that is what you are interested in.

 

Enter Return on Capital Employed

Is shareholders' equity the only funds that the company uses during the course of its business?

Of course not. The company could raise money - and often does - from other sources too, like debt, preference shares, warrants etc. Some even use lease financing.

Return on Capital Employed does not discriminate between different types of capital. It compares operating profit (less depreciation) against the total capital employed in the business. Thus it works at a more basic level. It reflects the overall earnings capacity of the business.

A small aside: Why does the RoCE take operating profit after depreciation?

This is because although depreciation is a non-cash expenditure, it is a payment towards the use of assets. At a slightly conceptual level, depreciation is the amount that a company sets aside to replace its assets in future. After all, every asset has a life and needs to be replaced sometime. Thus depreciation is a real cost of production and must be deducted from the operating profit.

 

Now that we have heard what each of them had to say...But before we get into the verdict let us take two examples.

Here is a company, Efficient Ltd. It's business is doing well and it manages to rake in a neat margin of 35% at its operating level. At the end of the year, here's how its numbers look in three diverse debt-equity scenarios.

Efficient Ltd.	Scene1	Scene 2	Scene 3
Equity	30	50	70
Debt	70	50	30
Sales	100	100	100
Operating profit	35	35	35
Depreciation	10	10	10
Interest	11	8	5
PBT	14	17	20
Tax	5	6	7
PAT	9	11	13
RoNW	29.9%	22.1%	18.8%
RoCE	25.0%	25.0%	25.0%

Reflected in these three scenarios above are three different financing patterns. In Scene 1, the company has funded 70% of its business from debt while at the other extreme, Scene 3, 70% of the capital is equity.

A company might fund its operations with debt or equity or varying combinations of both. In Scene 1, the high leverage has maximised returns to Efficient Ltd's shareholders, that is it has maximised RoNW.

A caveat - as we discovered earlier, although debt enhances returns to shareholders, it also increases the riskiness of the company (we'll discuss this a little later).

RoCE, on the other hand, is indifferent to the mode of financing. It remains the same across all three leveraging scenarios. Thus RoCE misses out on the crucial aspect of financing pattern.

 

But before you cast your vote in favour of RoNW, here is the other example

There are two companies operating in the same business - Strong Ltd. and Not-so-strong Ltd. And here is a glimpse of their financials.

.	Not-so-strong Ltd.	Strong Ltd.
Equity	100	150
Debt	50	0
Sales	100	100
Operating profit	54	61
Depreciation	15	15
Interest	8	0
PBT	31	46
Tax	11	16
PAT	20	30
RoNW	20.0%	20.0%
RoCE	25.9%	30.8%

Lo! Both companies have a RoNW of 20%. Now which would you choose? As a shareholder, should you be indifferent to both?

Hmm ...a dilemma? But look once again at the numbers.

Strong Ltd. has funded its entire business from equity while Not-so-strong Ltd. has funded about one-third of its business from debt.

Now, to belabour the point, debt adds to the Return to Net Worth but it also adds to the company's risk, since it entails a fixed obligation by way of interest. So in bad times, debt wears heavy on the company.

If two companies have the same RoNW, then, strictly speaking, the company having lesser debt is better, all other things being unchanged. It has lower fixed liabilities and less risk.

If you look closer, you will see that Strong Ltd. earns higher operating margins than Not-so-strong Ltd. Thus, operationally, Not-so-strong Ltd. is inferior to Strong Ltd. Then how come it has the same RoNW as Strong Ltd.? You know the answer - in good times, leverage adds to returns.

But the RoCE is very sensitive to operational strength. It is quick to spot anomalies in operations. While Not-so-Strong Ltd. has a RoCE of 25.9%, Strong Ltd. enjoys a much higher RoCE of 30.8%.

If we really want to gauge the efficiency of a company's operations, then the returns should be seen in relation to the total capital employed - whatever its form may be. What difference does it make if the funding has come in from equity or debt, so far as operations are concerned?

The verdict... a draw!

RoNW gives us the final picture of how a business is performing. To that extent, RoNW is a good indicator of how much you are getting on your investment in capital.

But do not stop at testing just how much your capital (shareholder's funds) has returned to you. You must also test if your capital is safe. There are plenty of instances when companies heavy with debt have eroded their net worth over a period of time.

Thus, RoCE is a better measure to test the viability of the company's operations; RoNW is better to gauge the returns that you get as a shareholder. In order to get a complete picture of a company's ability to generate returns, one needs to keep track of both these ratios - Return on Capital Employed and Return on Net Worth