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Company Analysis - ROCE, a Cocktail of financial ratios
Analysing a company with a single financial ratio
Financial ratio analysis is a key part in financial statement analysis of a company. There are different types of financial ratios and looking at each ratio gives us a little bit of information about the company.
Return on Capital Employed (ROCE) is the single most important financial ratio. Through this post, I will try to explain how to calculate ROCE. I will also explain how ROCE is a summary (cocktail) of all ratios and is sufficient enough to analyse any company irrespective of industry.
Return on Capital Employed
Return on Capital Employed can be divided into two key parts as under:
Numerator: Return generated by business
Denominator: Capital Employed in business i.e. amount invested in running business operations
Numerator: Return generated by business
Free cash flow generated by business in any given year gives us a good indication of return generated by business. Free Cash flow is the money left with the company at the end of the year after meeting operating expenses and capex.
Textbook definition of Free Cash Flow is Cash Flow from Operations minus Capex. I use a slightly modified version of Free Cash flow as under:
Free Cash Flows = Cash Flow from Operations minus Replacement/maintenance capex
Capex can be bifurcated into Expansion Capex and Replacement/Maintenance Capex. We may not subtract expansion capex as it can generate incremental cash flows to business unlike replacement/ maintenance capex. A company is mandatorily required to incur replacement/maintenance capex to maintain its existing cash flows. Replacement/maintenance capex can be in the form of upgradation of machinery to maintain competitive advantage, wear and tear of existing machinery, etc.
Hence Replacement/Maintenance Capex helps maintain existing cash flows from operations. Whereas Expansion Capex helps generate incremental cash flows from operations.
Denominator: Capital Employed in business
Capital Employed in business = Core Fixed Assets plus Core Current Assets minus free float (i.e. other people's money)
While arriving at Core Fixed assets, we need to subtract capital work in progress as the same is yet to generate cash flows. We also need to subtract recently completed expansion capex if the same has not generated any cash flows during the year. We also need to subtract non core fixed assets or unutilised fixed assets like unutilised land. Basically, we need to subtract all fixed assets which are not generating operating cash flows.
While arriving at Core current assets, we need to subtract surplus cash in business. We also need to subtract assets which are not related to business like loans and advances to related parties, ICDs, etc.
Some businesses generate free float like say advances from customers. Sometimes core sundry creditors can act as free float. Free float is the money which a company receives without interest and can partly fund the business operations. While Core Fixed assets plus Core current assets gives us the gross capital employed in business. We can subtract free float to arrive at net capital employed in business.
Significance of ROCE
Return on capital employed (ROCE) = Return generated by business / Capital employed in business
Analogy to ROCE is interest earned on Fixed Deposit during a year. ROCE is like the rate of Interest on Fixed Deposit.
Businesses which generate high ROCE attract a lot of competition due to supply/demand economics. In the long term, due to competition, ROCE keeps reducing year on year on account of supply and demand.
If a company is able to generate high ROCE year after year, then we can safely conclude that there is some inherent sustainable competitive advantage (in other words moat) in the business due to which it is generating high ROCE over multiple years.
As a general thumb rule, companies with ROCE greater than 20% over multiple years have a very good moat. Companies with ROCE between 10 to 20% have moderate moat. Companies with ROCE less than 10% are generally in highly competitive businesses.
There are few businesses which even generate ROCE of more than 100%. For example CRISIL Limited in CY2019 generated cash flow from operations of Rs 446 Crs against Capital employed in business of Rs 312 Crs indicating ROCE of 143%!!!
Before we jump to the conclusion that good ROCE means good moat, we need to first understand that financial statements give us an indication of the past performance and not the future performance of the company. Hence, good ROCE only indicates presence of good moat in the past. We need to further analyse and satisfy ourselves on whether the moat is still present in the company and is going to remain so in the future as well.
Why ROCE is cocktail of all financial ratios?
Financial Statement ratios can be broadly classified into four types:
Efficiency or Operating ratios
For detailed explanation of various ratios, you may refer to various resources available online. One such resource is Zerodha varsity. Here, I will try to explain how ROCE is a summary (cocktail) of all ratios.
Profitability ratios are Operating profit margin, Net profit margin, etc. These ratios are generally the percentage of sales i.e. topline. These ratios vary for each industry and give us an indication of profitability performance of the company as compared to peers in the industry. Shareholders are generally concerned only about the profit i.e. bottomline generated in absolute terms irrespective of profit as percentage of sales.
Numerator in ROCE provides us with the bottomline in absolute terms.
Efficiency or Operating ratios
Efficiency ratios indicate the efficiency with which assets of the company are utilised. Hence, these ratios measure sales relative to each asset.
While profitability ratios can be represented as Profits / Sales
Efficiency ratios can be represented as Sales / Assets
Profitability ratios X Efficiency ratios = Profit / Sales X Sales / Assets = Profit / Assets
Profit / Assets is nothing but ROCE. Hence, ROCE is also a summary of Profitability and Efficiency ratios.
With leverage ratios we can gauge the debt levels of the company. A company which keeps generating high ROCE over multiple years can fund its own growth. Hence, such high ROCE companies generally have low debt levels. We can indirectly arrive at leverage levels through ROCE.
Liquidity ratios reveal the level of current assets in relation to current liabilities. Companies with high ROCE generally generate enough cash flows to fund its growth and also to build surplus cash reserves. Hence, such high ROCE companies have surplus cash in their books. Surplus cash reserves ensure good liquidity ratios. Hence, we can indirectly gauge liquidity ratios through ROCE.
As we have seen, ROCE is a summary of all ratios and acts as a cocktail of all financial ratios. ROCE is the single most important financial ratio which can be used across industries. However, ROCE does not work for businesses which are into lending. That is the only drawback of ROCE.