Investors must look for the trend in ROC and its components in evaluating their investments
By N Sivasankaran
Return on Capital (ROC) is otherwise known as return on invested capital (ROIC) or return on capital employed (ROCE). This is an important performance measure which needs to be assessed by investors, especially debt investors (both retail and institutional). Let us discuss the nitty gritty of ROC in this article.
Return on capital (ROC)
It is computed by dividing the after-tax operating income of an entity by its invested capital. After-tax operating income is calculated as a product of EBIT (i.e., operating profit) and tax retention rate (equal to one minus tax rate). And invested capital is computed by subtracting current liabilities from the total of liabilities and shareholders’ funds. Capital employed is the sum of net fixed assets and net working capital. For instance, Himay Sahil Ltd (HSL), a hypothetical firm has after-tax EBIT of Rs 240 crore and its net fixed asset is Rs 1,500 crore and its net working capital is Rs 1,500 crore and its operating revenue is Rs 2,000 crore. Its capital employed (or invested capital) is Rs 3,000 crore. Therefore, its ROC is 8%. The ROC is the product of three variables; namely, operating profit margin, invested capital turnover and tax retention rate.
Operating profit margin (OPM)
It is computed by dividing the pre-tax operating income by the operating revenue of a firm. If the tax rate for HSL is 40%, then its pre-tax operating income (i.e EBIT) is Rs 400 crore. The OPM of HSL is 20%. The OPM of a firm could be decomposed into three components; namely, gross profit margin, selling general and administration expenses burden and depreciation burden.
Gross profit margin (GPM)
It is calculated by dividing the gross profit of a firm by its operating revenue for the period. If the gross profit of HSL is Rs 800 crore, then its GPM is 40% (i.e 800/2000 *100).
This metric assesses the SGA expense management efficiency of a firm. It is computed by dividing the earnings before interest tax depreciation and amortisation (EBITDA) of a firm by its gross profit. EBITDA is calculated by subtracting all the operating expenses excluding cost of sales and depreciation and amortisation from the gross profit of a firm. For HSL, if its SGA exclusive of D&A is Rs 300 crore, then its EBITDA is Rs 500 crore (i.e Rs 800-Rs 300 crore). Therefore, its SGA burden is 62.5%. This indicates that the firm’s SGA expense is 37.5% of its gross profit.
It is computed by dividing EBIT of a firm by its EBITDA for the period. EBIT is arrived by subtracting D&A from the EBITDA amount. If D&A for HSL is Rs 100 crore, then its EBIT is `400 crore. Hence, its depreciation burden is 80%, i.e, 400 divided by 500. This reveals that the firm’s D&A is 20% of its EBITDA.
OPM = GPM*SGA burden*Depreciation burden = 40*0.625*0.80= 20%.
The firm’s invested capital return is computed by dividing its operating revenue by its invested capital. For HSL, it is 0.67 times i.e 200/3000. The firm’s tax retention rate is computed by subtracting tax rate from one. For HSL, it is 0.60, i.e, 1-0.40. The ROC of HSL is 8%, i.e, 20*0.67*.60.
Hence, investors must look for the trend in ROC and its components in evaluating their investment candidates to improve their ROC. An ideal stock should have an increasing trend in GPM, SGA burden, depreciation burden, IC turn and tax retention rate.
The writer is associate professor of finance at XLRI School of Management, Jamshedpur