Calculation - Return Of Capital Employed(ROCE)

Q&A: Questions & Answers Investing Basics Q&A
1

hi,

I am trying to calculate the ROCE for Emmbi industries and I am not sure if I am doing it correctly.

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Capital employed = Equity + Non current liabilities = 856.85 + 296.02 = 1152.87

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EBIT = Net profit + Tax + Finance cost = 127.28 + 47.86 + 82.65 = 257.79

Now, ROCE = EBIT/Capital employed % = (257.79/1152.87)*100 = 22.36%

Where as Screener says

I have also checked last year ROCE to check if screener is reporting last year ROCE, which is also not matching with my calculation.

Is that calculation correct? What is the mistake I am doing here?

Emmbi latest results: http://corporates.bseindia.com/xml-data/corpfiling/AttachHis/1533e764-71fb-47d9-91e1-3153cc1d398c.pdf
Screenr: Emmbi Industries Ltd financial results and price chart - Screener

2

Hi, Returns signify operating profit. The figure in the snapshot you have shared is ‘Item no. 3’ i.e. Profit from operations (before all not operating income and expenses). This would be your numerator.

Capital employed includes following:
Shareholder’s equity + All Interest bearing liabilities.

Under non current liabilities LT borrowings should be included. Also, try to find out the nature of Other Long-term liabilities which I think would also be interest bearing loans. But Deferred tax or Provisions should not be included.

Hope it explains.

3

Thanks @Nolan.

If that is the case the denominator value decreases significantly causing ROCE to more than what my calculated value in my previous post (because from denominator we have to remove provisions and tax liabilities and there are no other liabilities here).

Even though calculation looks correct it’s not matching with screener. I tried with Sharda crop chem and same is happening there as well. Things are not matching. Are there other sources to verify?

4

I agree with you. Different analyst may use slightly modified definitions while calculating ratios. There could be two interpretations of Capital Employed:

  1. Total Assets - Current Liabilities (This would include provisions, deferred taxed and all interest bearing liabilities)
  2. Shareholders’ equity + Debt (This would exclude all liabilities which do not have interest payment as it may not be categorized as capital like Deferred taxes, Provisions etc.)

Sometimes it is also dependent upon the nature of operations/industry which warrants for certain modifications in definition to reflect accurate numbers.

To understand the disparity in quotes, you will probably have to read through the definitions being used to calculate ratios to understand different approaches being adopted by different analysts/sources.

5

Please check…if there is standalone or consolidated numbers confusion?

6

ROCE measures how much money the business earns, independent of its capital structure. The text book formula for ROCE is EBIT / Capital Employed. Different people have used different approaches to calculate ROCE. There is no right or wrong answer but the main thing is to maintain consistency.

Given below is the method I prefer to follow, others are welcome to comment how they find this approach.

A: Capital Employed
Look at the asset side of the balance sheet to find out where capital has been employed. For a normal manufacturing business this means 1) Fixed assets and b) Working capital.

  1. Fixed Assets: Take fixed assets at gross level, because that was the amount which was actually spent when the assets were bought. FA should include intangibles like patents, IP, goodwill etc. but exclude capital work in progress since it is yet to generate returns. Standard text books use Net Fixed Assets which I consider wrong. Net Fixed Assets is a fictional number.

  2. Working capital: This is current assets minus current liabilities. Let us break this down.

a. Current Assets: Take all current assets as given in the balance sheet. Also add such items which are classified non-current just because they are realizable in more than 1 year, but we know they are in the “normal” course of business. Examples of these are staff loans, deposits given to dealers, advances with government authorities for tenders etc. Add all of them judging each item individually.

b. Current Liabilities: Take all current liabilities as given in balance sheet. Add liabilities which are in the “normal” course of business but have been classified as non-current just because they are technically for more than one year e.g. advances received from dealers etc.

c. Now (a) minus (b) above gives the working capital deployed in business. I exclude deferred tax assets / liabilities from all the above.

Fixed assets plus working capital as calculated above gives the capital employed in business as on the balance sheet date. But since returns are generated over the course of the year, take opening & closing balances of each of the above and divide by two (opening balance is nothing but previous year’s balance sheet figure). This gives the “average” capital employed during the year. This is the denominator in the formula.

Now let us come to the numerator.

B: Returns
Here we want to find out how much money the business operation made. EBIT is usually easily available in the P & L Statement (PBT plus Interest). But make one adjustment:

  1. Add back accounting depreciation and deduct maintenance capex.

a. Maintenance capex: Total capex is available in the cash flow statement. From this, spending specific to expansion / acquisition etc. should be removed. Expansion capex will be available somewhere such as in the Annual Report, analyst concalls, management interviews etc. If nothing can be inferred from any source, assume all capex is maintenance capex. Also look at past trends for this.

This gives the numerator.

Now calculate the ROCE as “B” divided by “A”.

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7

Hi,

I think the answer for how to compute ROCE really depends on what you want to do with it.

Your denominator is capital employed which equity and non-current liabilities. This really means you are trying to find out what is the return that accrues to equity + debt holders. Therefore the numerator should reflect the profits that accrue to these 2 parties. Your calculation is correct from that respect. This method is useful when comparing different companies with different debt and tax structures but you dont want to consider that.

However another way to look at is that a part of the EBIT (taxes) is also payable to the Govt, a 3rd party in the equation. Therefore sometimes it makes sense to consider EBIT * (1 - tax rate) as the numerator. This is useful when you want to build the tax efficiency of the business also when looking at ROCE. You should use tax rate of the business in this case. Not that the tax benefit on the interest itself is not considered as you want to ignore the benefit of the debt structure when comparing companies.

A further modification is to use steady-state tax rate (example 30%). This can help understand how businesses are performing compared to other asset classes post tax. I get a close enough number to 15.69% when I do this, but I am not saying that this is how screener does it.

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8

Thanks @Chandragupta @shivramrca for the insights. They are very useful.

I figure out how Screener does this and it’s mostly matching with what Chandra has mentioned above.

Here is the formula:

(Operating profit - Depreciation - Tax)/(Net block - CWIP - Current Investments + Other assets - Other liabilities)

Or Denominator will be= Equity + Reserves + Borrowings (long term/short term/term loan) - CWIP - Current Investments

If I do the math I am getting the value which is matching with the screener.

Only difference is that it doesn’t take whole of Fixed assets into consideration and remove depreciation to get the netblock.