Understanding how a company makes its profits. How a company generates its ROCE?

DuPont analysis

Return on Capital Employed or ROCE
= EBIT / Capital Employed
= (EBIT/Sales) x (Sales/Capital Employed)


ROCE is determined by two elements:

1.  What is happening with profit margins.
2.  Sales generated per $1 of money invested (capital turnover)


1.  Profit Margins

Profit margins are determined by many different factors.

The key influences on profit margins are:

Prices

• Higher prices can boost margins.

Costs

• Particularly important is the split between fixed costs (cost that have to be paid regardless of the level of sales, such as rent and most wages) and variable costs (costs which vary with sales, such as raw materials).  
• Companies with a high proportion of fixed costs can see their margins change rapidly in response to small changes in turnover via a process known as operational gearing.

Mix of products

• Some sales are more profitable than others.
• A car dealer will make little profit on selling a new car but will make lots of profit on selling services and spare parts.
• A company can sell more sophisticated products at a higher price for its most profitable sales.

Volume sold

• Selling more products can boost margins where the company has a high proportion of fixed costs (i.e high operational gearing).
• This process can also work in reverse and is clearly seen in manufacturing companies.
• For example, an industrial plant will have costs related to buildings and machinery, energy, raw materials and wages.  
• Most of these costs are fixed and the company needs to sell a large amount of goods to cover them and break even.
• Once past break even, the fixed costs are spread over a larger amount of sales, which allows profits to increase rapidly.
• However, a sharp fall in sales pushes the company back towards break even and possibly into a loss if income cannot cover all the fixed costs.

By analysing these factors allows us to understand the business behind the profit margin numbers.

Profit margins which fluctuate over a period of time are a tell-tale indicator of a cyclical business (where sales move up and down in line with the general economy) and possibly one with high operational gearing.

• These businesses are more risky and their shares do not make suitable LONG TERM investments.
• Stable profit margins are a desirable characteristic of a business for long term investments.

Please spend time reading a company's annual report to see if it has anything to say about profit margins.

• Pay particular attention to any mention of changes in prices, sales mix and volume changes.
• High-quality companies grow by selling more (volume) and not just by charging more.
• A company which increases prices but does not increase sales is showing that its customers are responding to the price rise by buying less from them.
• This maybe a sign of trouble ahead and may lead to stagnating or lower profits in the future.

2.  Capital turnover

Capital turnover looks at how effectively a company is spending its money to produce sales.

A company can increase capital turnover by adopting some of these measures:


Boosting sales

• For example, increasing sales with new products.

Reducing money invested.

• Cutting working capital by holding less stock of finished goods, getting customers to pay their bills faster and paying suppliers later.
• Cutting the amount of money invested in new assets (capital expenditure, or capex), reducing spending on new assets or increasing efficiency by getting more sales for less investment.
• Getting rid of under-performing assets that have low capital turnover and low ROCE.

Additional notes:

How do you work out the capital employed or the amount of money a company has invested?

Capital employed 
= Total Asset - non-interest bearing Current Liabilities

Using the Asset side of the Balance Sheet:

#Capital employed 
= Total asset - Current Liabilities + Short-term borrowings


Using the Liability side of the Balance Sheet:

*Capital employed 
= Total Equity + Long-term Liabilities + Short-term borrowings
= Total Equity + other Long-term Liabilities + Long-term borrowings + Short-term borrowings
= Total Equity + other Long-term Liabilities + Total borrowings



How do you work out the ROCE?

ROCE = return on capital employed

Numerator equals earnings produced for all capital providers = normalised EBIT

Denominator includes debt and equity contributed to the business. This is also the money invested into the business.

ROCE is usually calculated using a company's average capital employed over a period of two years. 

ROCE = ( EBIT / average Capital Employed)   x 100%




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The mathematical equations:

Total Asset = Total Liabilities + Total Equity

FA + CA = CL + NCL + Eq

(FA + CA - CL) = (NCL + Eq)

(FA + CA - CL) + STBorrowings = (NCL + Eq) + STBorrowings

(FA + CA - CL) + STBorrowings = (LTBorrowings + Other LTLiabilities + Eq) + STBorrowings

(FA + CA - CL) + STBorrowings = (LTBorrowings + STBorrowings + Other LTLiabilities + Eq)

#Total assets - CL + STBorrowings = Total Borrowings + Other LTLiabilities + Equity

or

*FA + NWC + STBorrowings = Total Borrowings + Other LTLiabilities + Equity



#Capital employed = Fixed asset + Current Asset - Current Liabilities + Short-term borrowings

*Capital employed = Fixed asset + Net Working Capital + Short-term borrowings