HOW USEFUL IS THE RETURN ON CAPITAL EMPLOYED (ROCE) AS A PERFORMANCE INDICATOR
Enyi Patrick Enyi (ACCA, ACA, MBA, MFP, RFS)
Madonna University, Okija - Onitsha
Anambra State, Nigeria.
The use of the Return On Capital Employed (ROCE) as a performance indicator is questioned in this paper. The paper is using the premise that performance indication can only be meaningful to the user if it bears a true reflection of the relationship that it intends to measure. An empirical evaluation of financial statements of 16 firms listed on the Nigerian Stock Exchange reveal that ROCE as currently defined presents distorted and misleading financial ratio which bears no relationship with the actual capital usage of a firm. It also revealed that a true measure of efficiency in the use of capital resources cannot be done using capital employed as defined in a company’s balance sheet. This is because the balance sheet capital is a static measure of capital employed at a date and not for the entire period. Hence, the result to be obtained from such measurement would invariably be influenced by the static nature of the value of capital employed as at that date. A more refined approach considered the firm’s actual capital turnover (usage) ratio and presents an Enhanced Return On Capital Employed (EROCE) ratio measurement that correlates better with a firm’s capital employed using the Spearman’s correlation coefficient formula. The study recommends the replacement of the ROCE with EROCE for maximum effectiveness.
The first objective of financial reporting is to provide information that is useful to present and potential investors, creditors, and other users of a firm’s financial statement in making rational investment, credit and other important business decisions (Ezeagba, 2001). This is the reason why the use and interpretation of a firm’s financial results must be done with utmost care and desirable professional expertise.
The second objective is perhaps and most obviously to provide a basis for assessing the internal and external performances of the firm. The internal performance as to profitability, liquidity and expandability may be easily obtained with the use of comparative analysis of past to present period performance in the form of ratio analysis, while the external performance as to market valuation may be obtained equally through comparative analysis of the firm’s performance with its industrial standard, peer company and market standing of its shares.
Though established theories and practice in the area of financial accounting and reporting can easily show that the market value of a firm’s share (stock) bears a true reflection of its internal performance, recent theories are now establishing a psychological reversal of that relationship (Hall, J.H. and Brummer, L.M., 1999).
Whilst the internal performance analysis is required for guiding the management towards maximizing the shareholders equity (Lucey, 2003), the external performance analysis on the other hand is required by investors and other third parties to show how far the management has been able to do just that. With due respect to the position and findings of authors who may think otherwise, this paper maintains that a firm’s internal performance determines its external position in the stock exchange barring the economic forces of demand and supply of its stocks, which invariably is influenced by the firm’s performance.
Performance indication can only be meaningful to the user if it bears a true reflection of the relationship that it was intended to test. This is the reason why a critical review of the existing financial analysis and interpretational tools particularly the ratio which measures management efficiency and effectiveness in the use of available resources has to be made. Therefore, this paper will look at the return on capital employed (ROCE) and other viability indicating ratios from the perspective of effectiveness/correctness both in content and in use. The aim being to establish whether the formula, interpretation and use made of the Return On Capital Employed as currently defined and the corollary Return On Investment (ROI) correlates to the results obtained from empirical analysis of financial statements of 16 selected quoted companies on the Nigerian Stock Exchange.
As currently defined, the return on capital employed (ROCE) is a measure of efficiency of management in the application or use of the organization’s funds or resources in a given financial period. It is measured by comparing the profits made by the firm with the capital used in making the profit and set as a percentage or fraction (Egungwu, 2005). Well, we have no quarrel with that definition; however, for the definition to be fully acceptable, we must find answers to the following questions:
In attempting to answer the first question above, opinions differ on what should be termed “net profit” as applicable in the determination of the Return On Capital Employed. Whilst some posited that Earnings Before Interest and Tax (EBIT) is more suitable, others argue that Earnings After Interest but Before Tax (EBT) should be more appropriate, still some insist that Earnings After Tax (EAT) or Profit After Tax (PAT) should be the most preferred. Well, a critical look at each position will clarify the reasons for this study thus:
Earnings Before Interest and Tax (EBIT) – Not all organizations borrow to finance their operations. But for those that engages in borrowing, the interest element is the cost of using the borrowed fund. Therefore, the interest on such borrowing is a part and parcel of the firm’s operating costs for the financial period. If the fund were not borrowed, the increase in activities level attributable to the borrowed fund would not have been possible as existing finances couldn’t have carried the activities level beyond its own scope. Moreover, the borrowed fund becomes an integral part of the firm’s total capital employed for the purpose of achieving the period’s results. Hence, the exclusion of interest from the determination of the financial performance of a firm is inaccurate and therefore unacceptable.
Earnings Before Tax (EBT) also Profit Before Tax (PBT) – The profit before tax after interest has been charged is the true return on investment or capital employed for the financial period. The reason for this is obvious. To start with, tax is an appropriation of profit no matter how one looks at it. Secondly, tax assessment and payment decisions are outside the jurisdiction and prerogative of management as these are the exclusive preserve of the state through the various tax authorities. The least management could do is to take cosmetic decisions aimed mostly at reducing the effects of taxation in the form of tax incentives and relief such as capital allowances and deferred payments. Thus, if tax is seen as an appropriation of profit (which it is), then the true net profit is reached once the interest element has been deducted. This is the position of this paper.
Profit After Tax – Profit after tax is at best a measure of available profits for distribution and expansion after adjusting for government’s share. Yes, government as a regulator and protector of all citizens, corporate and human, has a share in the income of all as defined by the various tax legislations. Since an appropriation has already been made before arriving at profit after tax, this automatically disqualifies the latter as a true measure of performance.
Consequent to the above clarifications, any performance measure which failed to take all costs (expended or expendable) and all earned revenue into consideration cannot be suitably employed as a performance indicator.
To answer the second question as to what constitutes “capital employed”, we need to look at the definitions of the various components of capital and liabilities of a firm. The various components of the capital of a firm that was defined in Enyi (2005) as the amount set aside for the establishment and running of a business organization, include:
a) Owners Capital
b) Borrowed Capital; and
c) Working Capital
Owners Capital – Owners capital can aptly be referred to as shareholders funds in the balance sheet of all incorporated companies. It is made up as follows:
- Paid up capital in the form of fully paid up ordinary stock (share); and
- Reserves, which may comprise general, capital redemption, share premium, revenue and assets revaluation and many other unfamiliar reserves that can be created by a firm within the ambit of the laws establishing it.
Borrowed Capital – Borrowed capital as a means of financing operations or supplementing the existing owners capital is a popular and very widely used type of funding for enterprise operational activities. There are various laws regulating the issuance and use of borrowed capital in all the countries of the world, with each country differing in accordance with its own internal peculiarities such as religion and culture.
Borrowed capital may take the form of debenture stock, bonds, term loans or simply bank advances (overdrafts). Whichever type is in use in a firm, the common feature amongst them is the existence of a costing the form of interest payment.
Debenture stocks and bonds are usually issued in defined units; may have maturity periods and may also be transferable or discounted. Term loans on the other hand may be mortgaged to a particular project but may not be transferable or discounted, while short term advances in the form of bank overdrafts are usually procured to augment working capital mainly on revolving basis. Another classification of borrowed fund may include preferred stocks (preference shares). It is considered as borrowed capital due to the mode of its issue, remuneration and redemption.
Working Capital – The American Accounting Research Bulletin No. 43 in Osisioma (1997) defined working capital as a margin or buffer for meeting obligations within the ordinary operating cycle of the business.
A careful analysis into the components of working capital which include current assets such as cash and bank balances, stocks, debtors and receivables, discountable bills and prepaid expenses as well as current liabilities like creditors and all accruals will reveal that it is a veritable source of short term capital. It is however interesting to note that though working capital is so called, it is in fact not a capital but an asset especially when it has a positive value; it only becomes a capital when it has a negative value.
For a proper analysis of capital employed however, the component value for creditors and accruals must be added to other forms of capital to arrive at the true value of capital employed. This is because credit givers through their credit gesture have lent some valuable funds, though without a cost in most instances, to the firm during the financial period and it will only be equitable if such funds are included as part of the capital employed for that period.
Capital Employed – To calculate capital employed in a period, we must take cognizance of the components of capital as discussed above. Thus the true make-up of capital employed in a business for a financial period will include:
- All forms of ownership capital;
- All forms of borrowed capital; and
- The period’s current liabilities.
To measure the return on capital employed (ROCE), we simply divide the profit before tax (and not profit after tax for the reasons already given) by the computed value of capital employed for the period, and multiply the result by 100 to give it a per centum presentation. The interpretation of the result will show the period’s performance (supposedly) as a percentage of the capital employed (i.e. resource used in making the profit).
Problems of Using The Return On Capital Employed As A Performance Indicator – The main objective of this research is to show that the use of the ROCE as a performance indicator is though desirable but nonetheless spurious and capable of giving misleading information.
To start with, the true measurement of efficiency in the use of capital resources cannot be done using capital employed as defined in a company’s balance sheet. This is because the balance sheet capital employed is a static measure of capital employed at a date and not for the entire period. Hence, the result to be obtained from such measurement would invariably be influenced by the static nature of the value of capital employed as at that date.
More so, such a measure will produce a larger than life result as the capital employed at balance sheet date will always tend towards producing an average rather than the total resources employed. Also, when a firm has negative networth, the ROCE produced will be totally distorted and basically meaningless.
To be more precise, the true representation of the value of the resources employed in the operations of a firm in a given period can be found in the value of total operating costs for that period.
To calculate the value of total operating costs for a period, we simply deduct the profit before tax (PBT) from the total turnover.
Any result obtained from the measurement based on this new definition of resources (capital) employed will be known as the Enhanced Return On Capital Employed (EROCE). Thus, the formula for obtaining the Enhanced Return On Capital Employed is:
EROCE = Profit Before Tax / Total Operating Costs
EROCE = PBT / (Turnover – PBT)
PBT = Profit Before Tax (Earnings Before Tax)
The enhanced return on capital employed measures the return or profit on each Naira of expended by the firm for the financial period. This is the true measurement of the return on capital employed because the true capital employed by the business for the period is the amount expended on the period’s operations excluding capital expenditure.
The following data were extracted from the financial reports of 3 listed companies for the financial period ended 31st December 2003:
FMN VONO NBL
N(m) N(m) N(m)
a. Turnover 161,671.39 1,769.36 158,814.78
b. Profit Before Tax 4,992.86 80.65 40,388.86
c. Networth 5,067.66 211.99 26,186.75
d. Operating Costs (a-b) 156,678.53 1,688.71 118,425.92
e. ROCE ((b/c)*100) 98.5% 38% 154.2%
f. EROCE ((b/d)*100) 3.2% 4.8% 34.1%
Looking at the ROCE and EROCE we can see how misleading the results produced by ROCE can be. While the ROCE showed a performance of 98.5%, 38% and 154.2% for FMN, VONO, and NBL respectively, the EROCE showed 3.2%, 4.8% and 34.1% for the respective firms as well. However, a closer look at the ROCE figures will show how unreliable they are. It couldn’t have been possible for FMN to make a profit of 98.5 kobo out of every Naira used in operation or for NBL to make a return of 154.2 kobo out of every Naira used in operation. The fact remains that the industries under which the two companies operate flour milling and beer brewing are highly competitive and couldn’t have afforded any player in the industry the opportunity to make super profits. This is the distorted aspect of the data produced from the ROCE analysis. A look at the EROCE will show a more realistic information, i.e. data that can be related to the true position of the firm. Again, while the ROCE showed that FMN performed better than VONO, the true position was revealed under EROCE which revealed that VONO, though with a lower networth or capital employed achieved a superior performance than FMN.
The capital turnover rate (CTR) is the rate or number of times that the average capital employed was used for operations during the period. It measures the number of times the capital employed was turned over during the financial period. A high turnover rate reflects a position of bumper business activities while a low turnover rate indicates a slow moving business or over capitalized business. Again, when a firm achieves a low EROCE with a higher capital turnover rate, this indicates that the business of the firm gives little profit margin but allows for quick and high turnover, on the other hand, a high EROCE with a low capital turnover rate indicates that the business offers a high profit margin but with slow moving activity or that the business is engaged in monopolistic activities.
To show the inconsistency and unsuitability of the present method of measuring the return on capital employed (ROCE) as a performance indicator as well as the capital turnover rates, we considered the following data extracted from a study of financial statements of 16 selected companies listed on the Nigerian Stock Exchange for the period ended 2003:
COMPANY TURN- PROFIT NETWORTH OPERATN ROCE EROCE CAPITAL
ID OVER B4 TAX OF FIRM COSTS OF FIRM OF FIRM T-OVER
a b c d=(a-b) e=(b/c) f=(b/d) g=(d/c)
N(m) N(m) N(m) N(m) % % Times
FlourMills 161671 4993 5068 156678 98.52 3.19 31
Conoil 111218 7044 6772 104174 104.02 6.76 15
TIB 12215 1503 2377 10712 63.23 14.03 5
M & B 5909 620 639 5289 97.03 11.72 8
Mobil Oil 132607 7764 686 124843 1131.78 6.22 182
Morison 610 58 110 552 52.73 10.51 5
Berger Pts 7083 527 462 6556 114.07 8.04 14
Poly Prdts 4213 22 246 4191 8.94 0.52 17
Union Ven 322 6 23 316 26.09 1.90 14
Vono 1769 81 212 1688 38.21 4.80 8
FBN 160492 33504 27880 126988 120.17 26.38 5
NBL 158815 40389 26187 118426 154.23 34.10 5
UAC 68485 3514 8695 64971 40.41 5.41 7
Texaco 99956 7111 2007 92845 354.31 7.66 46
GSK 17494 2197 1841 15297 119.34 14.36 8
With the above table, we shall proceed to make further analysis and correlation tests.
TEST OF CORRELATION BETWEEN CAPITAL EMPLOYED AND ROCE
COMPANY CAPITAL ROCE
ID EMPLOYD OF FIRM
x y xy X(sqrd) Y(sqrd)
FlourMills 5068 98.52 499300 25684624 9706.22
Conoil 6772 104.02 704400 45859984 10819.44
TIB 2377 63.23 150300 5650129 3998.15
M & B 639 97.03 62000 408321 9414.16
Mobil Oil 686 1131.78 776400 470596 1280922.40
Morison 110 52.73 5800 12100 2780.17
Berger Pts 462 114.07 52700 213444 13011.80
Poly Prdts 246 8.94 2200 60516 79.98
Union Ven 23 26.09 600 529 680.53
Vono 212 38.21 8100 44944 1459.82
FBN 27880 120.17 3350400 777294400 14441.35
NBL 26187 154.23 4038900 685758969 23787.82
UAC 8695 40.41 351400 75603025 1633.29
Texaco 2007 354.31 711100 4028049 125535.52
GSK 1841 119.34 219700 3389281 14241.40
F-Atlantic 3800 56.45 214500 14440000 3186.31
TOTALS 87005 2579.52 11147800 1638918911 1515698.35
n = 16
Spearman’s Correlation Coefficient (r) = -0.08
TEST OF CORRELATION BETWEEN CAPITAL EMPLOYED AND EROCE
COMPANY CAPITAL EROCE
ID EMPLOYD OF FIRM
x y xy X(sqrd) Y(sqrd)
FlourMills 5068 3.19 16151 25684624 10.16
Conoil 6772 6.76 45791 45859984 45.72
TIB 2377 14.03 33352 5650129 196.87
M & B 639 11.72 7491 408321 137.42
Mobil Oil 686 6.22 4266 470596 38.68
Morison 110 10.51 1156 12100 110.40
Berger Pts 462 8.04 3714 213444 64.62
Poly Prdts 246 0.52 129 60516 0.28
Union Ven 23 1.90 44 529 3.61
Vono 212 4.80 1017 44944 23.03
FBN 27880 26.38 735575 777294400 696.09
NBL 26187 34.10 893103 685758969 1163.14
UAC 8695 5.41 47027 75603025 29.25
Texaco 2007 7.66 15372 4028049 58.66
GSK 1841 14.36 26441 3389281 206.28
F-Atlantic 3800 29.40 111719 14440000 864.34
TOTALS 87005 185.01 1942347 1638918911 3648.53
n = 16
Spearman’s Correlation Coefficient (r) = 0.71
From the line graph in figure 1, we can see the inconsistent nature of the ROCE as it rose meaninglessly above the 100% mark, moving up and down. But a look at the EROCE will reveal a smooth moving curve showing that none of the companies studied exceeded the 100% mark.
Again, the two tests of correlation coefficient revealed that while EROCE has a strong positive correlation of 0.71 with the capital employed or the networth of the business at the year-end, the ROCE on the other hand has a negative or near-no-correlation of –0.08 with the networth of the business at the same time, thus, proving that the Return On Capital Employed (ROCE) as presently defined is a misleading measure, while the Enhanced Return On Capital Employed (EROCE) as defined in this paper is a more suitable performance measurement tool.
The evidence adduced so far on the deficiencies of the ROCE as currently measured is too overwhelming to be attributable to mere errors. Financial statements should be interpreted in a manner that leaves no doubt in the minds of the users. A misguided interpretation of the firm’s financial results especially as relates to the efficiency/efficacy of management decisions is capable of having undesired effects on both the internal and external fortunes of the company. Therefore, it is the considered opinion of this paper that the use of ROCE as currently defined is erroneous and capable of misleading investors and other interested parties on the performance of an enterprise.
On the basis of the facts analyzed supra, this paper recommends a turnaround from the use of the Return On Capital Employed (ROCE) as currently defined and the consideration of the Enhanced Return On Capital Employed (EROCE) as defined in this paper, as a replacement, for the measurement of managerial efficiency in the use of capital resources. Doing this will ensure that the management of a firm gets their due accolades or rebukes as deemed appropriate.
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