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 a more useful ratio than return on equity to evaluate the longevity of a company.

This ratio is based on two important calculations: operating profit and capital employed. 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 be calculated by adding interest and taxes back into net income if need be.

Capital employed is a fairly convoluted term because it can be used to refer to many different financial ratios. Most often capital employed refers to the total assets of a company less all current liabilities. This could also be looked at as stockholders’ equity less long-term liabilities. Both equal the same figure.

Formula

Return on capital employed formula is calculated by dividing net operating profit or EBIT by the employed capital.

Return on Capital Employed = Net Operating Profit / Employed Capital

If employed capital is not given in a problem or in the financial statement notes, you can calculate it by subtracting current liabilities from total assets. In this case the ROCE formula would look like this:

Return on Capital Employed = Net Operating Profit / Total Assets – Current Liabilities

Where:

• Fixed Assets, also known as capital assets, are assets that are purchased for long-term use and are vital to the operations of the company. Examples are property, plant, and equipment (PP&E).
• Working Capital is the capital available for daily operations and is calculated as current assets minus current liabilities.

It isn’t uncommon for investors to use averages instead of year-end figures for this ratio, but it isn’t necessary.

Analysis

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 .2 indicates that for every dollar invested in capital employed, the company made 20 cents of profits.

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders’ equity generates.

So, a return on 1 means that every dollar of common stockholders’ equity generates 1 dollar of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.

ROE is also an indicator of how effective management is at using equity financing to fund operations and grow the company.

Formula

The return on equity ratio formula is calculated by dividing net income by shareholder’s equity.

Return on Equity Ratio = Net income / Shareholder’s Equity

Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not included in the calculation because these profits are not available to common stockholders. Preferred dividends are then taken out of net income for the calculation.

Also, average common stockholder’s equity is usually used, so an average of beginning and ending equity is calculated.

Analysis

Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor’s point of view not the company. In other words, this ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else.

That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors’ funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies’ ratios in the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.

Interpreting the Return on Equity

The return on equity is similar to the “return on assets”. Assets come from two sources: debt and equity. The ROE focuses on the latter. Return on equity measures profitability using resources provided by investors and company earnings.

A high return on assets shows than the business was able to successfully utilize the resources provided by its equity investors and the company’s accumulated profits in generating income. Nonetheless, just like any other financial ratio, the ROE is more useful if it is compared to a benchmark such as the average ROE in the industry where the company operates or the company’s ROE in the past years.

The amount of current assets that a company has on hand at any given time, in excess of its current liabilities, is known as its net working capital (NWC).

These funds are what allow a business to run its daily operations. One of the short-term assets held by many companies is the cash invested in its inventory. But if this inventory amount is relatively large compared to other assets, it can skew the perception of just how readily available a firm’s cash truly is for paying off short-term debts. Sometimes a company’s inventory can suffer from extremely low turn-over, or simply becomes outdated and difficult to sell.

The inventory to net working capital ratio allows you to calculate exactly what proportion of a business’s working capital is tied up in its inventory, giving you a more accurate picture of its liquidity position.

Stock (Inventory) to Working capital Ratio = Inventory / (Accounts Receivables+ inventory – Accounts Payable)

Cautions & Further Explanation

Analyzing a company’s inventory to net working capital ratio is best done over a number of periods to accurately identify trends in the use of a firm’s working capital.

Such trends can help to reveal any problems in a company’s regular operations, including the rising ratio values associated with heavy quantities of outdated stock, inferior purchasing control, and inefficient sales forecasts.

Ideally, you should use the inventory to NWC ratio at the same time as you examine a company’s inventory turnover rate, since stock that consistently turns over quickly will contribute far more positively to an organization’s level of liquidity.

Interpretation & Analysis

In general, the lower a company’s inventory to working capital ratio is, the higher its liquidity.

This will be particularly true for those businesses that hold large quantities of inventory and that require certain levels of cash to fund their operations.

While some analysts consider ratio values of less than 100% to be sufficient proof of a company’s liquidity, this value often proves to be too generic for every situation.

Inventory to WC ratios vary widely between industries and companies, and you’ll glean more meaningful information by using industry averages as a benchmark in your analyses.

AS3 revised in 1997 has recommended revised Cash Flow Statement [CFS] for listed companies and other industrial, commercial, and business undertakings in the private and public sector. It is at present recommendatory in character.

According to revised AS 3, CFS should be prepared in such a way as to report the cash flows during the period separately for operating, investing, and financing activities.

1. Cash Flows from Operating Activities.

Examples are as follows:

(a) Cash receipts from sale of goods and services;

(b) Cash receipts from royalties, fees, commission, and other revenue;

(c) Cash payments to suppliers of goods and services;

(d) Cash payments to employees;

(e) In the case of insurance companies, cash receipts and payments for premium received and claims and other benefits to policy holders;

(f) Payment and refund of income tax;

(g) Cash receipts and payments relating to futures and options contracts taken up for trading purposes.

2. Cash Flows from investing activities.

Examples of such activities are as follows:

(a) Purchase of fixed assets including intangibles and payments relating to capitalized research and development cost and self-constructed fixed assets.

(b) Cash receipts from sale of fixed assets including intangibles.

(c) Purchase of securities for cash such as shares, warrants, and debt instruments of other enterprises.

(d) Sale of securities for cash

(e) Loans and advances given to third parties

(f) Loans and advances collected from third parties

(g) Cash receipts and payments relating to futures and options contracts entered into for investment purposes.

3. Cash Flows from financing activities.

Examples of such activities are as follows:

(a) Cash receipts from the issue of shares and other similar instruments,

(b) Cash receipts from the issue of debentures, bonds, long or other short-term borrowing,

(c) Redemption of shares and repayment of amounts borrowed.

The following illustrations would make clear the preparation of CFS under AS 3 method and Traditional method.

Illustration 1:

Balance sheets of X and Y on 1-1-2001 and 31.12-2001 were as follows:

During the year, a machine costing Rs. 10,000 (accumulated depreciation Rs.3,000) was sold for Rs.5,000.

The provision for depreciation against machinery as on 1-1-2001, was Rs.25,000, and on 31-12-2001 it was Rs.40,000. Net profit for the year 2001 amounted to Rs.45,000. You are required to prepare cash flow statement.

You are required to prepare CFS under AS 3 [Revised] method.

Solution:

Notes:

1. Cash and cash equivalents include cash and bank balances and risk less short-term investments.
2. Cash flow from operations is computed in the statement itself instead of preparing a separate statement showing cash from operations as in the case of traditional method.
3. Figures given within brackets represent cash outflows.

The two components of working capital are current assets and current liabilities. The estimation of the amount of current assets and current liabilities to maintain a particular level of operation is not an easy task.

Inadequate working capital leads to disruption in the smooth production process while excess working capital increases the cost.

The estimation of working capital in case of trading and manufactur­ing concern is discussed here.

Manufacturing Concern:

The estimation of working capital for a manufacturing concern requires adoption of following steps:

(a) Determination of expected production per week or per month.

(b) Determination of cost for each element, i.e. Material, Labour and Overhead as well as Profit per unit.

(c) Calculation of amount blocked in each week/month for each element of Cost and Profit.

(d) Determination of operating cycle by estimating the Raw materials holding period. Processing time, finished goods storage period. Debt collection period. Creditor’s payment period. Time lag in payment of wages and overheads.

(e) Determination of Net block period. It is the period for which each element of cost remains blocked. For example, if Raw materials remain in stores for 2 weeks after purchase; Processing time is 2 weeks; Finished goods remain in stock for 3 weeks; Credit period extended to debtors is 4 weeks; and Payment for materials is made 2 weeks after purchase then, the Net block period will be:

[(2+ 2 + 3 + 4) – (2)] = 9 weeks.

(f) By multiplying Net block period as calculated in step (e) and the amount blocked for each element of cost as per step (c) we get the working capital requirement for each element of cost.

(g) By totalling all amounts as calculated for each element of cost and desired cash, if any, we get the total amount of working capital.

Example 7.1:

Determine the Working Capital requirement from the following information:

1. Expected Sales 13,000 units
2. Analysis of selling price:

3. Raw materials in store: 1 month
4. Processing time: 2 weeks
5. Finished product in store: 2 weeks
6. Credit allowed to debtors: 4 weeks
7. Credit allowed by creditors: 2 weeks
8. Lag in payment for wages and expenses: 1 week
9. Production is carried on evenly during the year and wages and expenses accrue in the same way.

Solution:

(a) Weekly Sales = 13,000/52 = 250 units

(b) Weekly Blockage:

Raw materials: 250 x Rs 8 = Rs 2,000

Labour: 250 x Rs 5 = Rs 1,250

Expenses: 250 x Rs 4 = Rs 1,000

Profit: 250 x Rs 3 = Rs 750

Accounts receivable is the amount owed to a company resulting from the company providing goods and/or services on credit. The term trade receivable is also used in place of accounts receivable.

The amount that the company is owed is recorded in its general ledger account entitled Accounts Receivable. The unpaid balance in this account is reported as part of the current assets listed on the company’s balance sheet.

When goods are sold on credit, the seller is likely to be an unsecured creditor of its customer. Therefore, the seller should be cautious when selling goods on credit.

Good accounting requires that an estimate should be made for any amount in Accounts Receivable that is unlikely to be collected. The estimated amount is reported as a credit balance in a contra-receivable account such as Allowance for Doubtful Accounts. This credit balance will cause the amount of accounts receivable reported on the balance sheet to be reduced. Any adjustment to the Allowance account will also affect Uncollectible Accounts Expense, which is reported on the income statement.

Example of Accounts Receivable

A manufacturer will record an account receivable when it delivers a truckload of goods to a customer on June 1 and the customer is allowed to pay in 30 days. From June 1 until the company receives the money, the company will have an account receivable (and the customer will have an account payable).

Cost of Maintaining Receivables

Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses and cash discount. Costs related with receivables and their calculation are as follows:

1. Cost Of Investment In Receivables

This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:

Cost of receivables = Investment in receivables X Opportunity costs

Here,

investment in receivables = (FC+ VC)/Days in year) X DSO

Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.

2. Bad Debt Losses

This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:

Bad debt losses = Annual credit sales X Percentage default customer

3. Collection Expenses

This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid for telephone and communication and so on.

4. Cash Discount

It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:

Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount

Objectives of Receivables Management

Following are the objectives of receivables management which will help us to understand the purpose of receivables:

1. To optimize the amount of sales
   2. To minimize cost of credit
   3. To optimize investment in receivables.
   4. To increase credit sales.

Therefore, the main objective of receivable management is to create a balance between profitability and cost.

Accounts receivable recorded in the financial statements

Usually, the businesses expect to receive money in the future, so it is to be added to the assets in the financial statement of the business. The accurate record keeping of this money that is receivable (accounts receivable) in the books of accounts are required to avoid any default in the payment due.

Few pointers connected to recording accounts receivable are as follows :

a. Establishing the practice of credit transactions:

The business may establish a practice of providing a credit policy to its buyers. This credit can be extended for a specified time period and any default in this payment usually attracts penalty. This practice of credit facility requires two parties to come to an agreement on the terms and conditions for such credit transactions. The provider of this facility should also verify the paying ability of the customer before agreeing to any terms and conditions.to prevent loss of cash inflow.

b. Generating invoices for the customer:

The businesses are required to generate invoices of the sales made or services delivered. The invoice should have details of the cost of goods and services sold to the customers. This generating of invoice ensures the recording of the credit transaction clearly in the accounts of the business. Further, a copy of the invoice is given to the customer to make the payment as per the agreed terms.

c. Tracking the payments received and the payment that is due to be received:

An accountant is required to track the payments received or due from the customers. The details of the method of payment and date of receiving payment have to be recorded in the customer’s ledger account. This ensures correctness of accounting of the credit amount. The businesses shall also generate timely reminders for dues pending to the customers.

d. Accounting for the accounts receivable

The accountant or the person responsible for taking due care of the account’s receivables must record all the due dates of the payments to be received. The timely and prompt recording of the accounts receivable leads to receiving the payments on time from the customers. Once the account receivable is recorded and payment is received, the account for the said party can be settled for good.

The important dimensions of a firm’s credit policy are credit standards, credit period, cash discount and collection effort. These variables are related and have a bearing on the level of sales, bad debt loss, discounts taken by customers, and collection expenses.

i) Credit standards:

A firm has a wide range of choice in this respect. At one and of the spectrum, it may decide not to extend credit to any customer, however strong his credit rating may be. At the other end, it may decide to grand credit to all customers irrespective of their credit rating. Between these two extreme positions lie several positions, often the more practical ones.

In general, liberal credit standards tend to push sales up by attracting more customers. This is, however, accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff-credit standards have opposite effects. They tend to depress sales, reduce the incidence of bad debt loss, decrease the investment in receivables, and lower the collection cost.

ii) Credit period:

The credit period refers to the length of time customers are allowed to pay for their purchases. It generally varies from 15 days to 60 days. When a firm does not extend any credit, the credit period would obviously be zero. If a firm allows 30 days, say, of credit, with no discount to induce early payments, its credit terms are stated as “net 30”.

Lengthening of the credit period pushes sales up by inducing existing customers to purchase more and attracting additional customers. This is, however, accompanied by a larger investment in receivables and a higher incidence of bad debt loss. Shortening of the credit period would have opposite influences: It tends to lower sales, decrease investment in receivables, and reduce the incidence of bad debt loss.

iii) Cash discount:

Firms generally offer cash discounts to induce customers to made prompt payments. The percentage discount and the period during which it is available are reflected in the credit terms. For example, credit terms of 2/10, net 30 mean that a discount of 2 per cent is offered if the payment is made by the tenth day; otherwise the full payment is due by the thirtieth day.

Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the discount period are lengthened. Such an action tends to enhance sales (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly), and increase the cost of discount.

iv) Collection Effort:

The collection programmed of the firm, aimed at timely collection of receivables consisting of monitoring the state of receivables, dispatch of letters to customers whose due date is approaching, telegraphic and telephonic advice to customers around the due date, threat of legal action to overdue accounts and legal action against overdue accounts.

Credit Analysis

Credit analysis is a process of drawing conclusions from available data (both quantitative and qualitative) regarding the credit worthiness of an entity, and making recommendations regarding the perceived needs, and risks.

The 5 c’s of credit analysis

Character

• This is the part where the general impression of the protective borrower is analysed. The lender forms a very subjective opinion about the trust worthiness of the entity to repay the loan. Discrete enquires, background, experience level, market opinion, and various other sources can be a way to collect qualitative information and then an opinion can be formed, whereby he can take a decision about the character of the entity.

Capacity

• Capacity refers to the ability of the borrower to service the loan from the profits generated by his investments. This is perhaps the most important of the five factors. The lender will calculate exactly how the repayment is supposed to take place, cash flow from the business, timing of repayment, probability of successful repayment of the loan, payment history and such factors, are considered to arrive at the probable capacity of the entity to repay the loan.

Capital

• Capital is the borrower’s own skin in the business. This is seen as a proof of the borrower’s commitment to the business. This is an indicator of how much the borrower is at risk if the business fails. Lenders expect a decent contribution from the borrower’s own assets and personal financial guarantee to establish that they have committed their own funds before asking for any funding. Good capital goes on to strengthen the trust between the lender and borrower.

Collateral (or guarantees)

• Collateral are form of security that the borrower provides to the lender, to appropriate the loan in case it is not repaid from the returns as established at the time of availing the facility. Guarantees on the other hand are documents promising the repayment of the loan from someone else (generally family member or friends), if the borrower fails to repay the loan. Getting adequate collateral or guarantees as may deem fit to cover partly or wholly the loan amount bears huge significance. This is a way to mitigate the default risk. Many times, Collateral security is also used to offset any distasteful factors that may have come to the fore-front during the assessment process.

Conditions

• Conditions describe the purpose of the loan as well as the terms under which the facility is sanctioned. Purposes can be Working capital, purchase of additional equipment, inventory, or for long term investment. The lender considers various factors, such as macroeconomic conditions, currency positions, and industry health before putting forth the conditions for the facility.

Credit Standards

Credit standards are the criteria a company uses to screen credit applicants in order to determine which of its customers should be offered credit and how much. The process of setting credit standards allows the firm to exercise a degree of control over the “quality” of accounts accepted. The quality of credit extended to customers is a multidimensional concept involving the following:

• The time a customer takes to repay the credit obligation, given that it is repaid
• The probability that a customer will fail to repay the credit extended to it

The average collection period serves as one measure of the promptness with which customers repay their credit obligations. It indicates the average number of days a company must wait after making a credit sale before receiving the customer’s cash payment. Obviously, the longer the average collection period, the higher a company’s receivables investment and, by extension, its cost of extending credit to customers. The likelihood that a customer will fail to repay the credit extended to it is sometimes referred to as default risk. The bad-debt loss ratio, which is the proportion of the total receivables volume a company never collects, serves as an overall, or aggregate, measure of this risk. A business can estimate its loss ratio by examining losses on credit that has been extended to similar types of customers in the past. The higher a firm’s loss ratio, the greater the cost of extending credit.

Credit Period

The length of a company’s credit period (the amount of time a credit customer has to pay the account in full) is frequently determined by industry customs, and thus it tends to vary among different industries. The credit period may be as short as seven days or as long as six months. Variation appears to be positively related to the length of time the merchandise is in the purchaser’s inventory. For example, manufacturers of goods having relatively low inventory turnover periods, such as jewellery, tend to offer retailers longer credit periods than distributors of goods having higher inventory turnover periods, such as food products.

A company’s credit terms can affect its sales. For example, if the demand for a particular product depends in part on its credit terms, the company may consider lengthening the credit period to stimulate sales. For example, IBM apparently tried to stimulate declining sales of its PCjr home computer by extending the length of the credit period in which dealers had to pay for the computers. In making this type of decision, however, a company must also consider its closest competitors. If they lengthen their credit periods, too, every company in the industry may end up having about the same level of sales, a much higher level of receivables investments and costs, and a lower rate of return.

Credit Terms

A company’s credit terms, or terms of sale, specify the conditions under which the customer is required to pay for the credit extended to it. These conditions include the length of the credit period and the cash discount (if any) given for prompt payment plus any special terms, such as seasonal datings. For example, credit terms of “net 30” mean that the customer has 30 days from the invoice date within which to pay the bill and that no discount is offered for early payment.

Credit Scoring

A credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money an individual, corporation, state or provincial authority, or sovereign government.

Credit assessment and evaluation for companies and governments is generally done by a credit rating agency such as Standard & Poor’s (S&P), Moody’s, or Fitch. These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.

Why Credit Ratings Are Important?

Credit ratings for borrowers are based on substantial due diligence conducted by the rating agencies. While a borrowing entity will strive to have the highest possible credit rating since it has a major impact on interest rates charged by lenders, the rating agencies must take a balanced and objective view of the borrower’s financial situation and capacity to service/repay the debt.

A credit rating not only determines whether or not a borrower will be approved for a loan, but also determines the interest rate at which the loan will need to be repaid. Since companies depend on loans for many start-up and other expenses, being denied a loan could spell disaster, and a high interest rate is much more difficult to pay back. Credit ratings also play a large role in a potential investor’s determining whether or not to purchase bonds. A poor credit rating is a risky investment; it indicates a larger probability that the company will be unable to make its bond payments.

It is important for a borrower to remain diligent in maintaining a high credit rating. Credit ratings are never static, in fact, they change all the time based on the newest data, and one negative debt will bring down even the best score. Credit also takes time to build up. An entity with good credit but a short credit history is not seen as positively as another entity with the same quality of credit but a longer history. Debtors want to know a borrower can maintain good credit consistently over time.

Factors Affecting Credit Ratings and Credit Scores

There are a few factors credit agencies take into consideration when assigning a credit rating to an organization. First, the agency considers the entity’s past history of borrowing and paying off debts. Any missed payments or defaults on loans negatively impact the rating. The agency also looks at the entity’s future economic potential. If the economic future looks bright, the credit rating tends to be higher; if the borrower does not have a positive economic outlook, the credit rating will fall.

For individuals, the credit rating is conveyed by means of a numerical credit score that is maintained by Equifax, Experian, and other credit-reporting agencies. A high credit score indicates a stronger credit profile and will generally result in lower interest rates charged by lenders. There are a number of factors that are taken into account for an individual’s credit score including payment history, amounts owed, length of credit history, new credit, and types of credit. Some of these factors have greater weight than others. Details on each credit factor can be found in a credit repo rt, which typically accompanies a credit score.

Short-Term vs. Long-Term Credit Ratings

A short-term credit rating reflects the likelihood of the borrower defaulting within the year. This type of credit rating has become the norm in recent years, whereas, in the past, long-term credit ratings were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of defaulting at any given time in the extended future.