Sunday, July 16, 2006

Ratio analysis trivia: Return on capital employed?

Return on capital employed as defined by Wikipedia goes something like this:

Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company is realizing from its capital employed (Total assets - current liabilities). The ratio can also be seen as representing the efficiency with which capital is being utilized to generate revenue. It is commonly used as a measure for comparing the performance between companies and for assessing whether a company generates enough returns to pay for its cost of capital.

The formulae used is: (Profit before interest & taxes) / Avg. Capital Employed

There is another way of computing this ratio:

(Profit after tax + Interest) / Avg. Capital Employed

The argument here is that since the capital employed can be broken up into two components: owners capital and borrowed funds, one should look at the returns to individual components, ie. return on owners fund and the return on the borrowed funds. From a company's perspective the same thing would be to find return on owners fund and cost of borrowed funds (interest). The return to shareowners is the profit after tax and the cost of borrowed funds is the interest. Simply put, PAT + Interest is the return that a company generates to from the capital employed.

The difference between the two ratios is that the first one takes pre-tax return on capital employed whereas the second computes the post-tax return over capital employed.

The question: which of these is the right way of computing the return on capital employed?


Aman Thakur said...

I would consider
(Profit before interest & taxes) / Avg. Capital Employed
as a better indicator when comparing companies.

This ratio shall not be distorted by capital structure and therefore shall serve as a better indicator of efficiency than just the ratio on shareholder funds and borrowed funds

Ravi Purohit said...

Aman: I was more inclined towards the other ratio. Since it provides gives you a clear idea of the return of capital employed by the various capital providers, shareowners funds and borrowings. CE = Shareowners funds + borrowings. And, after tax profit is a return that shareholders take home whereas interest paid is what the lender takes home. Intuitively PAT+Int at the Nr appeals to me.