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Gaining Financial Insights With The ROCE Tree Part 1

Estelle Métayer
Expert Author
Published: 2004-05-13

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Few professionals in competitive intelligence have attended a formal financial analysis course: yet, analyzing a company's financial statement is often part of the job. The following framework should be part of your portfolio of tools. It is geared toward those who understand financial terms, but do not know how to pull together financial ratios to "tell the story." We at Competia particularly like this tool for the following reasons:

  • It allows a simultaneous analysis of the income statement and the balance sheet

  • It allows comparisons between peers in the same industry or across a timeline

  • It is linked to the notion of shareholder value

  • Most of the information required comes from the financial statements you can easily access for private companies

  • This article is structured as follows:

  • Definition of the ROCE tree

  • Structure of the ROCE tree

  • Analysis of the information obtained based on a case study

  • Tips to make this analysis successful

  • Definition of the ROCE tree

    The ROCE analysis can be defined as follows:

    "Breaking down your organization's ROCE (Return on Capital Employed - This is the operating profit before tax as a percentage of the year beginning capital employed) into its key components so you can determine the effects of these value drivers on the overall performance of your business and how your key drivers relate to those of your competitors and industry peers."

    In simpler terms, the analysis can be explained in three stages:

    Stage 1: Understand the turnover of the capital employed : For each $1 invested in the company, how much revenue was generated?

    Example: If you have invested $100 million in capital in the company, and the company has generated $200 million in revenues, the ratio is 2. This means that for each dollar invested, you have generated $2 of revenues.

    Stage 2: Understand the return on revenue or operating profit: For each $1 revenue generated, how much profit/return has been created?

    Example: If a company has sales of $200 million, and the profit is $20 million, the ratio is 10%.

    Stage 3: By combining stages 1 and 2, you are able to see how much return has been generated from each $1 invested in capital in the company = the Return on Capital Employed

  • $1 capital --------------------------> how much revenue?

  • $1 revenue -----------------------> how much return?

  • Let's define the calculations for the various items we have mentioned:

    Capital employed: this is the capital that is used to run the operations of the company (Note: the operations only - for example, you would not include the intangible assets in the calculation). In this analysis, the capital employed is calculated as follows:

    Capital Employed =

         PPE (Property, Plant and Equipment - also called fixed tangible assets in European statements)
         + Other operating assets
         + Working capital (capital needed to run the operations of your company)

    Working capital =

         + Accounts receivable (you have manufactured and shipped the products/services, but the client has not paid yet - this is part of doing business)
         - Accounts receivable (this is the reciprocal - money you owe to your suppliers

    Return: in this analysis, the return is the profit made from operations and operations only.

    Return =

    - Cost of Good Sold (will include labour and raw materials)
    - Sales and administrative costs
    - Depreciation

    A few notes of caution:

    When calculating the return, please note that you will exclude any item which is financial and not operational in nature, such as interest earned on investments, or in the case of a recent acquisition, restructuring costs or good will.

    Terms can be different depending on the country of the company. For example, sales and administrative costs will be called overhead costs in Europe, and PPE will be called fixed tangible assets in North America.

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    About the Author:
    Estelle Métayer [email protected]>* is president of Competia <http://www.competia.com>. Competia is North America's leading consultancy and training organization for senior executives and analysts in Strategic Planning and Competitive Intelligence. Its flagship product, Competia.com, is the world's largest community, portal and magazine for strategy professionals. Competia.com enables thousands of registered users to access each month a wealth of resources: news on the advancement of their profession, practical and hands-on tools and analysis techniques especially designed to help them increase efficiency in their work. A former consultant at the international strategic consulting firm McKinsey & Company, Estelle has written and lectured widely on the process involved in turning the intelligence gained into actions. Estelle can be reached at [email protected] [email protected]>

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