Monday, August 29, 2011

How to evaluate profitability of a company: Return on Capital (ROC)

Investors can look into Profit & Loss accounts of a business to see the net profit (PAT) levels of business. But looking into an absolute value of profits says nothing about the profitability level of a company. All investors have a common objective of buying shares of good business.

But the phrase good business is a very general term. In term of finanance, a ‘good business’ can be evaluated by calculating its Return on Capital (ROC). Return on capital is expressed in percentage (%) of total “tangible capital invested” in business. In order to evaluate the profitability of a company the best tool we have in hand is the return on capital (ROC).

The advantage of knowing the profitability of a company (more than just PAT) is that investors can compare the percentage profitability levels of a company A with company B. The company with higher levels of profitability (ROC) will be better than the other. But this is not the case with PAT. Let us see an example:

PATProfitability (ROC)
Company A$ 500,0006%
Company B$ 250,00012%

As an investors, you must prefer Company B over A. But if you do not know the ROC% you will be tempted to invest in company A over B. The logic is very simple, a company which has better prospects of growing faster in future shall be preferred over others. Return on capital (ROC) calculation gives you just this idea, that how profitable a company is; how fast it has grown till date, and an estimate of future growth speed.

Now the hard part, PAT figures can be directly obtained from the profit & loss accounts (financial statements) of a company, but the return on capital (ROC) needs to be manually calculated. The objective of this article is to make our readers know how to calculate the profitability of a company (ROC). In order to buy shares of a “good business”, it is very important to know the ROC figures of a compnay.

Return on Capital (ROC) = PBIT / Tangible capital invested

PBIT (Profit Before Interest & Tax)

PBIT can be back calculated from Net Profit (PAT) by adding to it the interest and depreciation. All three figures PAT, interest & depreciation can be easily obtained form the profit & loss accounts of a company. In order to compare the profitability of two companies, it is better to use PBIT instead of PAT because PBIT brings companies in same platform. Different companies work in different geographical location having their own set of interest rates and local tax structures.

PBIT = Net Profit (PAT) + Interest + Tax

Tangible Capital Invested

Tangible capital gives an idea about the companies ‘requirement of funds’ to run its business. In addition to run its business a company will need some fixed assets (like land, building, machineries, furnitures etc) plus some working capital (liquid cash in hand) to pay its short term expenses (< 1 year).

Tangible Capital Invested = Working Capital + Fixed Asset

This invested capital creates profits (PAT). The objective of any company is to generate maximum profits with minimum capital investment. Lets take an example:

PATTangible Capital InvestedProfitability (ROC)
Company A$ 500,000$ 8,333,3336%
Company B$ 500,000$ 4,166,66612%

As an investor you would like invest in company B over A because it generates the same level of profits (PAT) by investing less capital. This shows that the company B has higher profitability than company A.

Working Capital
Working capital is the extra cash in hand after paying all current liabilities. Working capital is a very good indicator of short term financial richness of a company. Working capital can be calculated by substracting companies ‘current liabilies’ from ‘current assets’.

Working Capital = Currest Assets – Current Liability
Working capital is used by company to fund its payables, shorty term debts etc. On a day to day basis, companies are required to pay its vendors, pay their employees, maintain their office administration, pay their short term debts etc. These expenses (called current liabilities) shall ideally be funded form their current assets (account receiavbles from customer, finished good inventory etc). A company with slightly positive working capital is ideal.

A postive working capital means, even after paying their current liabilities, company still has cash in hand to fund their future business operation. This positive cash is just an “indicator of companies financial health” at that point of time. In may cases the working capital is negative due to delayed collection from customer, in such case companies often draw money from their cash reserves (reflected in balance sheet) to fund their current liabilites. Generally speaking a negative working capital should not continue within a company for a long time (say two years in a row).

From this formulae you will note that the smaller is the working capital the better will be the profitability (ROC).

Return on Capital (ROC) = PBIT / (working capital + fixed asset)

If working capital is zero it means company has just sufficient cash (current assets) to pay its current liabilities. But this is a very risky case, it is almost like living like ‘hand to mouth’. So this is the reason why company should always maintain a marginal positive working capital (say 1.2 times the current liability) so as to be prepared for any emergency fund requirement in future.

A very high working capital is also not good, not only it reduces the profitability figures (ROC) but it also shows that either company is maintaining very high inventory (current assets) or they are not investing their extra cash.

Note: in case a company has negative working capital, then to calculate ROC, working capital in hand (excess cash) can be taken as zero. But it must be noted that prolonged negative working capital is not acceptable.

Fixed Asset
Fixed assets of a company like building, machinery, furnitures etc are required to run day to day business oprtations. This is the reason why we consider Fixed asset as tangible invested capital. To summarize, in order to run you business one must have fixed assets and some working capital (say 50% of total current liability).

Fixed Asset = Gross Block – Current Asset
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