This is the first in a series of seven posts looking at some common ratios used to analyse financial statements.
The Return on Capital Employed (ROCE) ratio is defined as follows
Operating profit before interest x 100
Capital employed is the amount of money (capital) which is invested (employed) in a business. It can be calculated from the balance sheet (statement of financial position) as total equity plus non-current liabilities or total assets (current and non-current) less current liabilities.
There is a potential problem with the ROCE, which is what capital employed figure to use in the calculation. Normally, the year end figure is used, but might be higher than the capital employed at the beginning of the year. Some companies use a simple average figure, taking the average of the capital employed at the start and end of the year. Others use a rolling average, which might be best in a highly seasonal business. Whatever capital employed figure is used is a matter of judgement for the business. The important thing is to be consistent from one year to another with the calculations.
The ROCE tells us the return made on capital employed before any distributions of profits (e.g. taxation, dividends or interest). It can be compared to risk free returns like putting money on deposit. Normally anyone investing in a company would expect a reasonable return – approximately 15% – or more if the business is seen as risky.
As an example, you can get the 2010 annual report of Diageo ( owner of brand such as Guinness, Bailey’s and Bushmills) here. If I look at the income statement (p.106), I can see a profit before interest of £2,574m. Looking at the statement of financial position (balance sheet) (p.108), I can work out capital employed as total equity (£4,786m) plus borrowings from non-current liabilities (£8,177m) – I am keeping it simple and ignoring other non-current liabilities. This would give an ROCE as follows:
2,574 x 100
This equals 19.9%, which is quite a good return.