F1 7.03 Profitability Ratios: ROCE and ROSF

In this session on Profitability Ratios we shall look at Return on Capital Employed and Return on Shareholders Funds.

Returns

When an investor buys shares or debentures in a company they do so expecting a return on their investment. This is similar to the way that a saver would expect to earn interest from the money they hold in a building society account.

It is important for any business that it generates sufficient profits from its net assets to keep its investors happy and Return on Capital Employed (or “ROCE”) and Return on Shareholders Funds (“ROSF”) try to measure the rates of return being generated by a company.

Return on Capital Employed (ROCE)

ROCE is a measure of the rate of profit made by a business for its providers of long-term finance (i.e. its lenders and shareholders) and is reported as a percentage.

It is calculated using the following formula.

Illustration

A company’s statements are shown below.

In order to calculate ROCE we will use information from both the Statement of Profit or Loss and the Statement of Financial Position. The Profit from Operations (£1,750,000) is taken from the Statement of Profit or Loss and the total of Equity (£7,740,000) and long-term debt (£6,500,000 in non-current liabilities) are found in the Statement of Financial Position.

ROCE = 1,750/(7,740 + 6,500) x 100 = 12.29%

Evaluating ROCE

It is usually good for a company’s ROCE to be higher than its comparator (e.g. a previous period or a competitor) and bad if it is lower. For example, if a company’s ROCE changed from 17% in the previous year to 14% in the current year we would say that the ROCE had worsened.

ROCE: reasons for change

There are several reasons why ROCE might have changed from, or be different to, its comparator. We can consider these reasons in terms of how the different elements of the formula, i.e. Profit from Operations, Long-Term Borrowings and Equity have changed.

ROCE: a note of caution

ROCE is a very widely used ratio. Prioritising its use over other ratios has been criticised however, as it can result in management taking actions that will improve ROCE in the short-term but will damage the business in the longer-term.

For example, a manager might consider cutting staff training costs as this will boost profits in the short-term and cause an immediate improvement in its ROCE but of course doing so will damage profitability in the longer-term as staff will be less well trained.

Another example would be a manager delaying the purchase of new equipment. Doing so is likely to boost profits in the short-term (as depreciation charges on its equipment will be lower) and may also mean that the company can delay raising additional funding in order to purchase the new equipment. Both of these effects will increase ROCE in the current period but might damage the business as it will be using older, less effective equipment.

Return on Shareholders Funds (ROSF)

ROSF measures the rate of return made by a business from its equity and like, ROCE, is presented as a percentage.

It is calculated using the following formula

Illustration

A company’s statements are shown below.

In order to calculate ROSF we shall use the Profit for the Year (or Profit after Tax) from the Statement of Profit or Loss and the total of Equity taken from the Statement of Financial Position.

ROSF = 920/7,740 x 100 = 11.89%

Evaluating ROSF

It is usually good if a company’s ROSF is higher than that of its comparators (e.g. the previous year) and bad if it is lower. So if a company’s ROSF was 25% and its main competitor had a ROSF of 10% we would view the company’s performance as being good.

ROSF: reasons for change

There are several reasons why ROSF might have changed from, or be different to, its comparator. We can consider these reasons in terms of how the different elements of the formula, i.e. Profit after Tax and Equity have changed.

Question 1

A company’s statement of profit or loss and statement of financial position are shown below.

Question 2

A company’s statement of profit or loss and statement of financial position are shown below.