June 2019 - Trade Brains

Hello Readers! In today’ post, we will be exploring the formula and the concept behind the Return on Capital Employed or ROCE.

The topics we shall cover in the post are as follows,

Formula and calculation
How to calculate NOPAT?
How to calculate Capital Employed?
The conceptual and interpretation of the formula and closing thought

1. Formula and calculation

Return on Capital Employed, as the name states, is the profit generated by the total capital used by the company for its operations for a period. It is widely used as a measure of profitability in the financial and the investment community. Although not commonly used around three decades ago, it has traveled a long way to even occupy center stage in the decision making of some portfolio managers and retail investors.

ROCE is computed as the percentage of Net Operating Profit after Taxes (NOPAT) upon the total long-term capital employed.

Return on Capital Employed = NOPAT / Total Capital Employed

Since the NOPAT is generated over the financial period which the Capital Employed is a balance sheet item and is normally represented at a period in time, some investors argue that the use of ROCE based on average Capital Employed during a period is a better metric.

The calculation for that is as given below

Return on Capital Employed = NOPAT / Average Capital Employed

Where, Average Capital Employed = (Opening Capital Employed + Ending Capital Employed)/2

The denominator of the above expressions implies that ROCE can also be defined as the return earned by the business as a whole or alternatively as the return generated by the capital contributed by both the creditors and the equity holders of the firm together.

In the case where the debt-financed component of capital is very low, the ROCE should give a value closer to ROE for similar earnings than a company which operates with a highly leveraged position.

2. How to calculate NOPAT?

The NOPAT or the Net Operating Profit After Taxes are calculated on the basis of two key inputs, EBIT and the TAX rate. In India, we have a corporate tax rate of approximately 30% for companies with revenues greater than ₹250Cr and around 20% for companies with revenues less than ₹250Cr.

The NOPAT calculation is pretty straightforward and can be done as per the equation below,

NOPAT = Earnings Before Interests and Taxes (1-Corporate Tax Rate)

NOPAT = (Profit before Taxes + interest payments + one time adjustments) (1-Corporate Tax Rate)

The black box here in this equation is the one-time adjustments, this includes earnings and expenses which are not regularly generated through operating activities of the company. These may include litigation expenses, loss/gains from the sale of assets, gain/loss due to asset revaluation of inventory, etc.

(However, if a company makes these kinds of expenses or gain regularly, it would require deeper inquiry on the side of the investor)

3. How to calculate Capital Employed?

The calculation of the denominator part of the equation is fairly simple and can be done from the line items reported on the balance sheet of a company.

Since the Capital Employed as mentioned before refers to the total capital raised from both the debt holders of the firm and also the equity holders, the formula should reflect contributions of both the capital provides to the assets of the company.

Capital Employed = Total assets – Total current liabilities.

This could also be shown as,

Capital Employed = Shareholders Equity + Non-current liabilities

4. The conceptual and interpretation of the formula

Most investors in the financial world like to see that the company they are about to invest in has a ROCE value greater than the Weighted Average Cost of Capital or WACC. WACC best defined as the minimum return a company should get subject to its unique capital structure.

If the ROCE of a company is greater than the WACC then the company is said to generating value for its shareholders and it is advised that the shareholders continue to hold the company in their portfolio. If the company’s ROCE is less than WACC then it is said to be destroying shareholder value and since equity holders are the last paid in the preference order of payments it is advised that equity holders stay out of such a company.

The calculation of WACC or the minimum return to be achieved the company is slightly complicated however a non-finance retail investor who could instead compare ROCE by arriving at his own required rate of return.

Since most retail investors may not be familiar with the computation and the vagaries of WACC, we feel it would be beneficial to use the following thumb rule to come up with your own required rate of return.

Required Rate of Return (%) = (Risk free bond rate + inflation rate + market risk premium) margin of safety

Where the market risk premium refers to the additional premium an investor would expect for investing in markets for most cases it would be better to take a value between 3%-5%.

Assuming an interest rate on a 10-year Indian Government bond is 8.2 percent, inflation rate of around 8 percent, a market risk premium of 3% and a margin of safety of 20 percent,

Required Rate of Return (%) = (8.1+8 +3) 1.20= 19.1 * 1.20 = 22.9%

Now if a company generates a ROCE greater than 22.9% then the company is creating value at a rate greater than the rate of return we calculated above and could be a target for shortlisting for investments.

Although not entirely foolproof, ROCE provides a lot of insight into the working business model of a company. Furthermore, an investor could gain better insights if he/she were to compare the evolution of the ROCE value for the last 5 to 6 years of company to form an opinion.

Levin Jenson

Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.

You might have heard the phrase ‘Cash is the king’.

A cash-rich business means that the company has enough cash left after paying all its expenses and debts. For the company with high cash, it simply means more liquidity and opportunities for the business.

However, very high cash is also not good for a company as it means that the company is leaving potential investment opportunities. Overall, low cash can affect business stability and high cash can reduce its efficiency.

And therefore, it is really crucial to understand the cash position of business before investing. In this post, we are going to discuss how to evaluate the cash-rich businesses to understand whether the company has low, sufficient or excess cash.

Cash and cash equivalents

When it comes to evaluating the cash position of a company, the investors look into the cash and cash equivalents (CCE) section of the balance sheet.

These are the company’s assets that are cash or can be converted into cash fast. Here, cash equivalents can be defined as the assets that can be converted into cash within 3 months like Money market funds, Short-term Government bonds, Treasury bills, Marketable securities etc.

All cash and cash equivalents are recorded in current assets segment of the balance sheet and are the most liquid asset of a company. Now, let’s understand the two common scenarios with respect to the cash level of a business.

Case 1: Low cash

When a business has low cash, it can be little worrisome for the company as it may have or will face some problems to pay short-term obligations.

In case of sufficient cash, companies can easily settle short-term debts (obligations), make an in-time purchase of new inventories/equipment, buy into lucrative investments/new technology, grab mergers and acquisition opportunities, increase dividends etc.

However, lack of adequate cash may push the company towards potential short-term problems. As a thumb rule, avoid investing in companies with low cash balance.

Case 2: High Cash

Although high cash helps a company in staying out of trouble of short-term obligations, supporting regular business operations in tough times, funding in its growth, superior performance etc. However, many times, excess cash be a little unfavorable.

Too much cash in company’s balance sheet simply means that the company is leaving potential investment opportunities to invest in the growth of its business operations or investments in other higher return instruments.

As Warren Buffett used to say- “Cash is the king. But it’s not much help if the king just sits there and does nothing.”

Too much cash reflects the inefficiency of the management to utilize it properly.

How to evaluate the cash of a business?

The cash position of a company can be evaluated using cash to current assets ratio. This ratio reflects the percentage of the total assets by cash and cash equivalents

Cash to current assets ratio = (Cash and cash equivalents)/(Current assets)

Although ideal cash and cash equivalents depend highly on the industry, however, as a thumb rule, cash to assets ratio of more than 40% can be considered to be excessive cash for the company.

Now, let us calculate the cash to current assets ratio of Hindustan Unilever (HUL) from its balance sheet.

(Source: Yahoo finance)

From the above statement, you can find the cash and cash equivalents (CCE) and total current assets of HUL over the years. For the year ending March 2018, the cash to current assets ratio turns out to be equal to 5.57%, which can be considered decent. (Quick note: You need to check this ratio over the past few years and compare with the competitors to better understand the cash position of HUL).

A word of caution:

Although having high cash is good for businesses, but it is equally important to understand the source of that cash i.e. where that cash is coming from?

There are different ways for a company to pile up cash. Apart from the profitability of the business operations, a few other ways to build cash is by taking debt or selling its assets. And both of the later two ways to generate cash is not favorable for a company as a high debt means greater interest obligations. Further, selling the assets to pile up cash may affect the future profitability of the company.

Therefore, you should always check the source of cash for the cash-rich businesses. You can find out this by looking at the cash-flow statement of a company.

In the cash flow statement, check the cash from operating activities. If this is consistently increasing, it’s a positive sign and means that the company is able to generate profits from its core businesses operations. Further, also check the cash from investing activities to find out purchase or sale of assets. Finally, also look into the debt obligations of the company for the long-term and find out its trend over years.

Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companies, feel free to check out this awesome online course on Introduction to Financial Statements & Ratio Analysis.

Bottom line

The cash of a business can be roughly evaluated by navigating the cash and cash equivalent section in the company’s balance sheet. Here, cash to current assets ratio is used to check the cash level of a company.

A company should have sufficient cash to effectively run its short-term operations. However, huge cash can also be little troublesome for a company as it reflects the management’s inefficiency to use the cash productively.

That’s all. I hope this post is useful to you. Happy Investing!!

Kritesh Abhishek

Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting