Ratios enable to form an insight into the different aspects of the performance and financial situation of a reporting entity, by calculating the relationships between various values of the accounts. The results of these calculations must be interpreted in light of the entity's strategy and targets, of its past results and of the results of its competitors or broader industry averages.
As one of the main aims of the reporting entity is to maximize the wealth of its owners in the medium and long term, an important question to pose when starting the analysis of the entity is whether this aim has been achieved. Profitability, from the owners' point of view, means how much profit attributable to them has been produced, given their investment in the entity. The profit attributable to the owners is, as explored above, the net profit (normally after tax), whilst the owners' investment is represented by the equity, making the Return on Equity as follows:
ROE = net profit / equity.
Although the owners have directly invested only the amount of money represented by the share capital and the share premium reserve (see chapter 3 above), their interest in the entity is represented by the entire equity, as this includes other reserves of capital accumulated by the entity from the use of its own assets, i.e. profit, or from their revaluation. Hence, the equity is made of capital that in various forms and more or less directly is attributable to the owners.
A more detailed aspect of the profitability of the entity explores the amount of wealth that the entity has created by using the resources made available for its operations. We are looking, in this case, at the operating profit, i.e. the profit made from the operations, regardless how these are financed (remember that operating profit is calculated before deducting the cost of financing). The operating profit was made possible by the use of the resources that normally employed in the entity for its operations. These are represented by the that amount of assets that is financed by long term sources of capital, such as equity and long term liabilities. Hence, the formula for capital employed is:
Capital employed = equity + long term liabilities
This means that the capital employed includes all the non-current assets and those current assets, which are constantly employed. Examples of this part of the current assets are: the oil in long pipelines, whereby a certain amount of oil must be constantly present in the pipeline for the pipeline to work, despite this oil is a current asset and despite its very fast movement, it still represents a constant investment; grocery on the outlets' shelves, whereby there need to be an average amount of grocery constantly on the shelves for the business to operate, and regardless of how fast this grocery turns over, that capital is constantly invested in that grocery.
Seen from a different point of view (refer to the accounting equation explained in chapter 3), this formula is also:
Capital employed = total assets - current liabilities
In this second version the capital employed is seen as the total amount of assets from which the volatile element of current assets is removed. The volatile element of current assets is that part of current assets financed by current liabilities, which are affected by a similar volatility. Once again, this leads to considering the capital employed as the amount of capital that is constantly or normally employed.
Hence the formula for Return on Capital Employed is:
ROCE = operating profit / capital employed.
Whether you decide to use operating profit including exceptional events or you prefer to stick with the underline performance, i.e. the performance that does not consider the exceptional events and the discontinued activities, depends on the aim of your analysis; are you investigating the performance of a specific period of time, or are you trying to understand the potential of the entity in its core operations?
Further analysis will most likely break in two avenues: one aimed at exploring the margins, i.e. the level of prices in comparison with the costs of producing and selling, and the other aimed at exploring the pace of the capital turnover, i.e. how fast the capital employed is renewed in a year. Formally, this is done by calculating respectively Return on Sales and Asset Turn Over:
ROS = operating profit / sales ATO = sales / capital employed
The obvious relationship ROS X ATO = ROCE is quite meaningful. It says that the profitability of the core operations is made of a combination of pace of the turnover of the capital and margins. In other terms, if an entity's strategy is based on selling high volumes of products or services at low prices, this analysis will most likely show high ATO and low ROS. Typical examples of such a strategy are found in the retail industry, where the large chains of retail shops embark in fierce price competitions to lure customers from each other aiming at expanding their volumes of sales as much as possible. Obviously their margins per unit of product are reduced to the minimum. If an entity's strategy is based on selling products or services to selected segments of the market at high prices, this analysis will most likely show high ROS and low ATO. Typical examples of such a strategy are found in the deluxe products industries, e.g. precious objects, jewel erase, etc. where a high margin for each unit of product sold is obtained but the volume of sales is relatively low.
The combined effect of margin and volume, i.e. ROS and ATO can lead to a better ROCE in either of the strategies. Although it is normally possible to identify quite clearly if the strategy of an entity is more on the high-volume-low-margin or low-volume-high-margin direction, often attempts are made to increase both volumes and margins. Typically, you should reflect on the accounting effects of new lines of premium products in the high-volume-low-margin context, e.g. the 'organic' product line in a supermarket chain; the margins per unit will increase and the volume will be, probably, unaffected. On the other hand, you should reflect on the effects of a new line of less pricy (and less expensive to produce) clothing to be added to a prestigious brand; the margins per unit will be marginally, if at all, reduced, but the volumes will increase significantly as an entire new segment of the market is targeted.
Select a number of entities, of which you have some knowledge, and which are operating in the same industry, obtain their accounts and work out the three ratios: ROCE, ROS and ATO. You should be able to position them in a matrix as in figure 7. Their positions will most likely confirm your prior knowledge about their brand strategy but also, maybe, reserve some unexpected results.
Figure 7 - matching brand strategy with accounting results
Further, you will find it useful to calculate other ratios, aimed at exploring the components of the ROS and ATO.