There are several advantages of being aware of ROCE of a company (more than just PAT). Investors can use profitability levels (ROCE, PAT) of one company and compare it with other. Lets take an example company A & B. The company with higher ROCE will be considered better for investment. Let us see an example:
An investor must prefer Company B over A as B's ROCE is better. But if one does not know the ROCE concept, then by just looking at PAT, he/she will be tempted to invest in Company A. The investing logic is simple, a company which has prospects of faster growth shall be preferred for investing. Return on capital employed (ROCE) gives us this idea. It shows us how profitable a company is and how fast it can grow its profits in times to come. ROCE measure profitability of a company from point of view of owners. Suppose you want to generate annual income of say $10,000. In order to generate this income there are two possibilities. One possibility asks you to invest $100,000 and get return of $10,000/year. The other possibility asks only $90,000 and provides $10,000/year. Which option will you choose? Its obvious that the second option is more profitable. ROCE looks at profitability of business from this angle
. $100,000 & $90,000 is called as capital employed and $10,000 is the return on capital employed. But if ROCE is so effective way to measure profitability of a company then why lot of investors does not use it?
Measure Profitability of a Company using ROCE
The hard part with ROCE is that; where PAT figures are directly available on profit & loss accounts, return on capital employed (ROCE) needs to be manually calculated. In this article we will see how to measure profitability of company using ROCE. To buy shares of good business, it is very important to know the ROCE figures.
|Return on Capital Employed (ROCE) = PBIT / Capital Employed
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 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 locations. Working in different locations imposes different interest rates and local tax structures.
|PBIT = Net Profit (PAT) + Interest + Tax
Employed capital gives an idea about how well company is using its funds to run its business. Company generates its funds from shareholders equity and debt it takes from banks etc. Idea of measuring profitability of company using ROCE is to know how much profit a company can generate from its capital employed.
|Capital Employed = Shareholders Equity + Debt
This invested capital creates profits (PAT). The objective of any company is to generate maximum profits with minimum capital investment
. Lets take an example:
An investor would like invest in company D over C because it generates the same level of profits (PAT) from less capital employed. This shows that the company D is more profitability than company C.
Most Profitable Companies in India 2015
(Updated as on July'2015)
||P & G Hygiene
||GlaxoSmith C H L