Analysis of the Enterprise
In this lesson, you’re expected to learn about:
– return on capital employed
– cost of goods sold
– overheads and other expense ratios
We’re now ready to start looking in depth at a company’s financial performance, starting with the enterprise.
Let’s begin by understanding and analyzing how we calculate the return that an enterprise provides by exploring a concept known as return on capital employed.
Return on Capital Employed (ROCE)
Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed.
In other words, return on capital employed shows investors how many dollars in profits each dollar of capital employed generates.
ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into consideration long-term financing. This is why ROCE is useful ratio to evaluate the longevity of a company.
This ratio is based on two important calculations:
– Operating profit
– Capital employed
1) Net operating profit is often called EBIT or earnings before interest and taxes. EBIT is often reported on the income statement because it shows the company profits generated from operations.
EBIT can also be calculated by adding interest and taxes back into net income if need be.
2) Capital Employed is the amount of capital that is employed in the operation. Thus, it refers to the total assets of a company less all current liabilities.
It is also known as net operating assets.
Return on capital employed is calculated by dividing net operating profit by the employed capital.
Return on Capital Employed (ROCE)
= Net Operating Profit / Capital Employed
= Net Operating Profit / (Total Assets – Current Liabilities)
Analysis of ROCE
The return on capital employed ratio shows how much profit each dollar of employed capital generates. Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated by each dollar of capital employed.
For instance, a return of 0.2 indicates that for every dollar invested in capital employed, the company made 20 cents of profits.
Investors are interested in the ratio to see how efficiently a company uses its capital employed as well as its long-term financing strategies.
Companies’ returns should always be higher than the rate at which they are borrowing to fund the assets.
For example, if a company borrows at 10 percent and can only achieve a return of 5 percent, they are losing money.
To find COGS as a percentage of sales, we can divide this figure by sales. Therefore:
COGS % = COGS / Sales
Gross Margin = Gross Profit / Sales
Gross margin and the cost of goods sold effectively tell you the same thing.
For example, if you have something that cost you 77.5 cents and you sell it for $1, your COGS is 77.5 cents and your gross margin is 22.5 percent.
Mark-up is calculated by dividing your gross profit by your cost:
Mark-up (%) = Gross Profit / Cost
= 22.5 / 77.5
Let’s first look at distribution. This includes the cost of the sales team as well as the cost of physically transporting the goods to customers.
Along with the expenses itemized on the P&L, the notes to the accounts also provide information which can help to explain why operating profits are behaving as they are.