Treasurers need to make decisions based on the financial performance of many different organisations, including our own. So, we need to understand how to evaluate financial information in a rigorous and consistent way.
IT’S NOT JUST PROFITS
Profits are vital, especially to shareholders and other investors. But how much investment does the business need, to earn the profits? If the capital investment is too great, the profits aren’t so attractive.
RETURN ON CAPITAL
Treasurers use ratios to compare different businesses. For example, return on capital ratios divide profit by capital, to calculate a percentage rate of return on the capital investment.
|
RETURN ON CAPITAL |
|
Profit ÷ Capital |
|
= Rate of return % |
TREASURERS NEED TO UNDERSTAND
Return on capital is a fundamentally important performance measure.
Key applications for treasurers are to:
- Appraise business investment proposals;
- Evaluate creditworthiness; and
- Support investor relations.
DIFFERENT PERSPECTIVES
Return on capital ratios include:
- Return on equity (ROE); and
- Return on capital employed (ROCE, sometimes pronounced ‘rocky’).
Practitioners vary both the measure of profit and the measure of capital, depending on which investors they’re considering.
ROE
ROE is an essential ratio for shareholders. It looks at the after-tax profits earned for shareholders, using the shareholders’ equity capital.
|
|
ROE |
|
Investors |
Shareholders |
|
Profit |
Profit after tax |
|
Capital |
Equity |
BETTER OR WORSE?
Let’s see how the treasurer uses ROE to take a shareholder’s perspective, to analyse two different companies. Their financial performance includes:
|
COMPANY |
A |
B |
|
$m |
$m |
|
|
Profit after tax ÷ Equity |
6
40 |
7
80 |
|
= Rate of return % |
15% |
8.8% |
Company B is earning greater profits of $7m, compared with Company A’s $6m. But Company B is using twice as much equity capital to earn its profits. Company B is using equity of $80m, compared with Company A’s $40m.
As a result, Company B is earning an inferior return of 8.8% for its shareholders, compared with Company A’s 15%.
All other things being equal, Company A is the better investment.
AVOID RED HERRINGS
Like many financial ratios, the final calculation of ROE is a simple division of one number by another. The trickier bit can be remembering what to divide by what, especially if a situation contains red herrings.
Red herrings are non-relevant information, which is potentially distracting. You need to use your practical abilities to identify and use the relevant information only.
LET’S LOOK AT ANOTHER EXAMPLE
Company C has reported: operating profit €12m, profit after tax €7m, equity €70m and non-current liabilities €30m. How would you calculate the return on equity?
RELEVANT INFORMATION
The information we need for our ROE calculation is the profit after tax of €7m, and the equity of €70m.
|
ROE (€m) |
|
|
Profit after tax ÷ Equity |
7
70 |
|
= ROE |
10% |
The other data in this question isn’t relevant for the ROE calculation.
However, it would be relevant for ROCE.
ROCE PERSPECTIVE
The important difference between ROE and ROCE is their perspective:
- ROE assumes the viewpoint of the shareholders only; while
- ROCE takes the wider perspective of all capital providers, not just shareholders.
PROFIT AND CAPITAL
To reflect this wider perspective, ROCE’s profit and capital measures are both different. Keeping it simple at this stage, the profit measure is normally operating profit. Again, keeping it simple for now, the capital definition is normally equity plus non-current liabilities. This wider measure of capital, defined for the ROCE evaluation, is known as capital employed.
|
|
ROCE |
|
Investors |
All capital providers |
|
Profit |
Operating profit |
|
Capital |
Capital employed |
ROCE FOR COMPANY C
We’ve already calculated Company C’s ROE as 10%. Now let’s calculate its ROCE.
The information we need is:
Operating profit = €12m
Equity = €70m
Non-current liabilities = €30m
Now we need two steps:
- Capital employed; then
- ROCE.
1. Capital employed
This is the total of equity and non-current liabilities:
70 + 30 = €100m
2. ROCE
|
ROCE (€m) |
|
|
Operating profit ÷ Capital employed |
12
100 |
|
= ROCE |
12% |
USING FINANCIAL STATEMENTS
The treasurer often needs to extract important information from financial statements. For example, Company D’s financial statements include:
|
PROFIT OR LOSS (€m) |
|
|
Operating profit Interest and tax |
24 (10) |
|
PROFIT AFTER TAX |
14 |
|
FINANCIAL POSITION (€m) |
|
|
Equity Non-current liabilities |
140 60 |
|
CAPITAL EMPLOYED |
200 |
Q. Using the financial statements (above), how would you calculate company D’s: (a) ROE; and (b) ROCE?
Refining ROCE assessment
Depending on the context, and available information, the ROCE evaluation is sometimes refined. We might refine either or both of:
- The capital measure; and
- The relevant profits.
(a) Capital employed: refinements
Two potential adjustments are:
I.Short-term borrowings, if they are being used as part of longer-term capital, to add to capital employed; and
II.Cash and cash equivalents, to net off.
It’s essential to confirm all definitions in practice, and then apply them consistently.
(b) Profits and tax
Profits for the ROCE evaluation are sometimes after tax. When ROCE is used in value-added analysis, it is always after tax. This is because the tax authorities must always be paid first. Any remaining surplus for the investors will be after tax.
A. (a) ROE = 14/140 = 10%; (b) ROCE = 24/200 = 12%
____________________
Author: Doug Williamson
Contributor: Paul Cowdell
Source: The Treasurer magazine
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