Read on Twitter
Return on capital employed (ROCE):
ROCE is one of the most important financial ratios out there.
Today I will try to explain it in a simple way. Grab a bar of dairy milk silk and let's get started.
ROCE is one of the most important financial ratios out there.
Today I will try to explain it in a simple way. Grab a bar of dairy milk silk and let's get started.
Say, after witnessing the recent rally in Indian pharma stocks, you decided to start a pharmacy business.
And it required a capital of 10 lakhs. You poured in your own funds of 4 lakhs and borrowed 6 lakhs from the bank and started the business.
And it required a capital of 10 lakhs. You poured in your own funds of 4 lakhs and borrowed 6 lakhs from the bank and started the business.
The business sales were 20 lakhs and you made an operating profit of 2 lakhs for the year.
Now you want to know how much returns your business has actually made.
Now you want to know how much returns your business has actually made.
After thinking for a while, you have understood that profits divided by capital should give you the return on capital.
You have done the math and came up with a return on capital of 20% on your business.
And Boom there you go.
You have done the math and came up with a return on capital of 20% on your business.
And Boom there you go.
ROCE tells you how well a business is generating profits on capital employed.
The formula is ROCE = EBIT/Capital employed
Whereas
EBIT = Earnings before Interest & taxes
Capital employed = Equity + Debt
The formula is ROCE = EBIT/Capital employed
Whereas
EBIT = Earnings before Interest & taxes
Capital employed = Equity + Debt
From looking at the above example, you can observe that
EBIT = Profits = 2 lakhs
Equity = Own funds = 4 lakhs
Debt = Bank funds = 6 lakhs
You got a return on capital of 20%
But stop not, there is more to dive in.
EBIT = Profits = 2 lakhs
Equity = Own funds = 4 lakhs
Debt = Bank funds = 6 lakhs
You got a return on capital of 20%
But stop not, there is more to dive in.
Let's break the formula further.
You can rewrite the formula like this
ROCE = (EBIT/Sales) * (Sales/Capital)
Sales can be cancelled on both numerator and denominator sides. So you can't blame me for that.
You can rewrite the formula like this
ROCE = (EBIT/Sales) * (Sales/Capital)
Sales can be cancelled on both numerator and denominator sides. So you can't blame me for that.
Now, comes the interesting part. You can further write this as below
ROCE = EBIT margin * capital turnover
Let's take a moment to acknowledge and understand these two new guests that have appeared.
ROCE = EBIT margin * capital turnover
Let's take a moment to acknowledge and understand these two new guests that have appeared.
EBIT margin:
It is pretty simple. It tells your business profit margin.
The formula is EBIT/Sales
You have earned 2 lakhs on a sales amount of 20 lakhs bringing your EBIT margin to 10%
It is pretty simple. It tells your business profit margin.
The formula is EBIT/Sales
You have earned 2 lakhs on a sales amount of 20 lakhs bringing your EBIT margin to 10%
Capital turnover:
This one measures the efficiency of a business's use of capital in generating sales
The formula is Sales/Capital
So with a capital of 10 lakhs, you generated revenue of 20 lakhs bringing the ratio to 2 times.
The higher the ratio, the better the efficiency
This one measures the efficiency of a business's use of capital in generating sales
The formula is Sales/Capital
So with a capital of 10 lakhs, you generated revenue of 20 lakhs bringing the ratio to 2 times.
The higher the ratio, the better the efficiency
By substituting these two in the new formula,
You would get the same return on capital of 20% (10% margin * 2 times )
Generally speaking, look for companies that generate a return on capital above 15% and also which is stable and growing.
You would get the same return on capital of 20% (10% margin * 2 times )
Generally speaking, look for companies that generate a return on capital above 15% and also which is stable and growing.
To conclude, Return on capital depends upon the operational efficiency and capital efficiency of a business.
That's it, folks. Hope you enjoyed reading. Like and retweet if you find the thread value-added. Have a great day.
That's it, folks. Hope you enjoyed reading. Like and retweet if you find the thread value-added. Have a great day.
