Analysis of the Statement of Financial Position (AQA A Level Business): Revision Note

Return on capital employed (RoCE)

• The return on capital employed is also known as the primary ratio

• It compares the profit made by a business to the amount of capital invested in the business

• It is a measure how effectively a business uses the capital invested in the business to generate profit

• Return on capital employed is a key performance indicator that can be compared over time and also with competitors and other potential capital investments

• Return on capital employed is expressed as a percentage and can be calculated using the formula

$\mathrm{Return}\mathrm{on}\mathrm{capital}\mathrm{employed}=\frac{\mathrm{Operating}\mathrm{profit}}{\mathrm{Capital}\mathrm{employed}}\times 100$

Interpreting RoCE

• The RoCE rate differs between industries so comparison across sectors is not recommended

  • It can be compared with other forms of return, such as interest rates on savings and with other businesses within the same industry

• The higher the RoCE rate, the better, as it indicates that the business is profitable and using its capital efficiently

  • Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved

Ways to increase RoCE

1. Make more profit without spending more money

   • If a business earns more money (profit) but doesn't take on extra loans or investment, it will get more return from the same amount of capital

   • Example: A shop sells more products without having to buy new equipment

2. Use less capital to make the same profit

   • If a business keeps profit the same but uses less money overall (e.g. sells off unused equipment or pays off debt), it will be more efficient with what it has

   • Example: A company stops renting a second office and saves money, but still keeps sales and profit steady

Return on investment

• Return on investment evaluates the financial return generated by a specific investment decision

  • Such as purchasing new equipment, launching a new product or opening a new location

  • It answers the question: was this particular investment worth making?

• Return on investment is expressed as a percentage and calculated using the formula

$\mathrm{Return}\mathrm{on}\mathrm{investment}\left(\mathrm{ROI}\right)=\frac{\mathrm{Net}\mathrm{return}\mathrm{from}\mathrm{investment}}{\mathrm{Cost}\mathrm{of}\mathrm{investment}}\times 100$

Gearing

• The gearing ratio shows the long-term financial structure of the business

  • It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used to fund a business

  • The outcome is expressed as a percentage

  • In short, it shows how reliant a business is upon borrowed money

• The gearing ratio is calculated using the formula

$\mathrm{Gearing}\mathrm{Ratio}=\frac{\mathrm{Non}\mathrm{Current}\mathrm{Liabilities}}{\mathrm{Capital}\mathrm{Employed}}x100$

• Capital employed can be calculated by subtracting current liabilities from total assets

Interpreting the gearing ratio

Highly geared business

• In a highly-geared business more than 50 percent of the capital employed is long-term loans

  • Substantial levels of interest will need to be paid on this high level of borrowing, which means

    • The level of profit available to pay as dividends to shareholders is reduced

    • Profit available to retain within the business is limited

    • The business is likely to be considered a risk for further investment

    • It is also likely to face difficulties in raising further loan capital 

Steps to reduce gearing

• A highly-geared business may take steps to lower its ratio by:

  • Issuing more shares to create further share capital

  • Retaining more profits to avoid further borrowing

  • Repaying loans to lower interest costs for the business 

Low geared business

• A low-geared business has less than 50 percent of its capital employed as long-term loans

  • The business may be missing out on the opportunity to access finance without the need to dilute existing shareholders' control

  • This is especially true when interest rates are very low, as has been the case in the UK over the last 15 years

  • Lenders such as banks are more likely to approve loan applications from low-geared businesses

  • An unwillingness to access loan capital may indicate a risk-averse business, which may deter investors

 Steps to increase gearing

• A low-geared business may take steps to increase its ratio by

  • Buying back shares to reduce share capital in relation to borrowing

  • Obtain more loans