Return on capital employed
Return on capital:
Return on capital or return on equity invested or capital employed is the percentage return on investment. The return is generated from the profit the business makes from its activities. This is the formula for calculation of return on capital employed:
Return on Capital Employed is calculated by Earning Before Interest and Tax / Capital Employed
To understand how we can improve the return we generate from the capital employed, it is also important to look at what we’re investing in. Investments can be stocks, bonds, mutual funds, real estate or interest-bearing accounts, etc.
Some investments are much riskier than others while some investments yield a much greater return than others. Most investors prefer more return and less risk.
How to improve return on capital employed?
Now moving on to how we can improve our return
we yield on our investments- there are multiple ways to do so. Let take a look
at the most effective ways.
- Reduce costs and increase sales: By reducing costs, sales value will increase and greater sales will lead to more profit being generated. This can’t be done simply by spending less but finding out about the nature of each cost and how it affects the selling price and profits. Lowering the selling price won’t be the only solution if costs aren’t being reduced too. But higher sales don’t necessarily mean higher profits or higher returns. By reducing costs, the company can become more efficient too if they try to find areas where unnecessary costs are being generated. This will lead to operational efficiency as well. We need to analyze how much percentage change the reduction of each cost brings in the sales and evaluate the percentage increase in profits due to the reduction in cost percentage. Hence, the combination of lower costs and higher sales will provide a better return on capital.
- Disposal of assets: Selling off surplus assets and inefficient assets that don’t generate much revenue or increase costs can also improve your return on capital employed. Assets that cost more than they generally are of no use to any business. For example, a production company should sell off the machine that has outlived its efficient days. This way there will be less capital employed and more returns leading to a better return on capital employed percentage.
- Level of operation: The scale at which the business operates is also very important to look at while talking about return on capital. If the business is small scale, it will have high fixed costs and the return will be lower. However, if the business is high scale and increasing the volume can reduce fixed costs, the business should be doing so in order to maximize profits. This is also known as economies of scale.
- Debt financing: Furthermore, the company should try to finance its business through debt financing rather than equity financing. Equity financing dilutes shareholders holding since the number of shareholder increases meaning the net profit would be distributed among a higher number of investors.
Conclusion:
A perfect combination of all these ways can lead to a better return. Many things go overlooked in business and to have the maximum return generated on all the capital invested, a company should analyze each and every aspect of its business.
Return on capital employed tells the shareholders the value of a company and how profitable the company is. A higher return is obviously better but we can’t judge the value and performance of a company by looking at just one figure.
The trends of many ratios over the years and across the industry has to be taken into consideration.
Just generating lots of profit with no actual efficient operations taking place in the business will lead to a greater return, but when taking the bigger picture into account, it is a loss for business because of the inefficiency.
Quick ratio
Quick
Ratio:
Quick ratio can best the best determinant of liquidity measures within a company. As a matter of fact, it can be seen as a measure to validate the organization’s ability to meet its day to day expenses and other short-term liabilities like accounts payable and accrued interest expenses.
In this article, we will discuss the ways how a company could use to improve the quick ratio when the calculation shows that ratio performance is not meet the expectation of company management.
Formula:
The quick ratio or acid-test ratio can be
calculated through the following formula:
(Current assets – inventory) / Current Liabilities
How
to improve quick ratio?
Often the greatest organizations are faced with the greatest challenges pertaining to liquidity, to an extent where they are often forced to shut down.
Therefore, given the overall importance of ensuring liquidity within the firm, it is really rudimentary for organizations, regardless of their size to ensure that they follow certain protocols to improve their quick ratio.
- Increasing Sales and Inventory Turnover: There is no doubt to the fact that Sales and Inventory Turnover are some of the greatest determinants to gauge business standing. However, in order to improve the liquid resources your business has in hand, it gets pivotal to increase the sales for your company. In return, this will increase inventory turnover. Having greater turnover means greater cash in hand for the company, and hence, greater sales.
- Improving Invoice Collection Period: Long-term Debts extended to clients are often one of the biggest reason for a company’s inability to meet its expenses. As a result, it often gets challenging to manage cash, and despite the fact that one might have greater sales and assets (long-term debtors), the liquidity position might get gruesome. It also increases the company’s exposure towards risk, because of the chance of clients defaulting on those debt gets higher, and significantly increases the probability of increased bad debts for the company. Therefore, by giving long-debtors discounts in order to attract them to pay early, your organization can quickly convert long term assets into cash, thereby increasing the liquidity you have at your disposal.
- Paying off liabilities quickly: Current liabilities tend to have an inverse relationship with quick ratio, which should, therefore, be decreased. This can be achieved by ensuring that you are able to pay back liabilities in due time.
- Discarding unproductive assets: Often in an organization, the corporation has certain assets lined up which do not generate any considerable revenue for the company. These assets need to be identified and then discarded in order to get cash against those assets. This cash can then be taken for short term liquidity of the company, hence improving the quick ratio of the company.
- Drawings: As far as drawings are concerned, it can be seen that drawings from business owners should also be prioritized and kept at a minimum. If your business is a partnership, then there should be strict preventions to ensure that there are no withdrawals in the form of drawings, because that just takes a heavy toll on the existing cash in the company.
Conclusion:
In addition to the features listed above, it can further be stated that the best manner to ensure that your company has an improved quick ratio is to ensure that there are strategies and plans decided which can ensure that there are sufficient funds and paybacks to facilitate the working capital of the business.
By investing less in inventory (adopting policies like Just in Time), you can ensure that you do not have a lot of money tied up in inventory.
Similarly, by ensuring that you are able to keep your credit limits in check for long term debtors, your business can have sufficient cash on hand to be able to manage the day to day expenses in a viable manner.
It is absolutely crucial that one does a holistic analysis of the Current Assets and Liabilities for the company so that it is easy to analyze which aspect needs to be highlighted and taken care of.
Debt ratio
Introduction:
Debt to equity ratio is computed by dividing the total liabilities of the company by shareholders’ equity. This ratio is represented in percentage and reflects the liquidity of the company i.e. how much of the debt owed by the company is used to finance the assets as compared to the equity.
The
investors and especially the potential equity shareholders always use this
ratio to assess company financing strategy since they are concerning about to
profit that could deliver to them after paid to creditors, banks, as well as
treasury shareholders.
Before moving to the discussion the limitation and advantages of debt to equity ratio, now let see the formula first,
The
formula:
Debt to equity = Total liabilities / Total shareholders’ equity
A high debt/equity ratio is usually a red flag indicating that in the case of solvency the company will go bankrupt with not enough equity to cover the debts. A low debt/equity ratio indicates lower risk since the debt is lesser than the available equity.
A debt-to-equity ratio is an important part of ratio analysis performed under financial analysis. It is included under gearing ratios along with time interest earned ratio, debt ratio, and equity ratio.
Gearing ratios are a metric used to demonstrate the funding of an entity’s operations i.e. whether it was covered through debt or the investment made by shareholders.
An
ideal debt/equity ratio is around 1:1 which means equity must be equal to
liabilities; however, the optimal ratio depends more on the type of industry
and may vary from industry to industry.
The
following is the discussion of key importance and limitation of debt to equity
ratio:
Importance of debt to equity ratio:
Debt to equity ratio is particularly significant for the financial analysis of a company. A list of points explaining the importance of the debt/equity ratio is mentioned below:
- Debt to equity ratio is an important tool used in financial analysis to enable potential investors to examine the health of a company. A high debt to equity ratio is an indication of low liquidity. It means that the entity is unable to finance its obligations through the cash and reserves and is dependent on the creditors. The probabilities of the entity to go bankruptcy are high. It is a sign that new investors their money in.
- Debt to equity ratio also helps in understanding shareholder’s earning. A high debt implies that high interests are paid by the company which reduces profits significantly. A decrease in profit is a decrease in dividends paid to the ordinary shareholders.
- Debt to equity ratio is used by lenders and creditors as well when a small business applies for the loan. It signifies the entity’s credit trustworthiness and how regular they are in regards to payment of installments.
- It is helpful for management to demonstrate the competition in the market. Debt to equity ratio can help the entity understand its performance against the competitors. This may help the management in making improvised decisions to reach the ideal debt/equity ratio.
Limitations of debt to equity ratio:
- Debt/equity ratio may misguide the potential investors as well since a low debt to equity ratio can be a result of the company not appropriately financing the assets with the debt obtained. This is an indication of technical inefficiency which would result in lower returns even if the debt/equity ratio is low.
- The optimal debt/equity ratio that is 1:1 can’t be widely used for all the industries out there. A capital-intensive entity may have a high debt/equity ratio indicating that net assets have been regularly maintained and financed through the debts obtained which would increase returns in the future due to higher production. However, a low-capital industry doesn’t need to invest in factories and types of equipment hence its optimal ratio should be around 1:1. This is one of the major limitations of the debt/equity ratio since it can only compare similar companies’ financial performance.
- Debt to equity ratio requires context to understand. A person who isn’t well versed with accounting may not be able to defer the terminologies mentioned in the balance sheet. A clear understanding of the terms equity and liabilities is required to understand the concept and objective of the debt/equity ratio.
Profitability Ratios
Overview:
Profitability ratios are a group of quantitative values that measure a company’s profitability against its revenue, cost of sales, equity, and balance sheet assets. It is a metric that measures a company’s ability to generate income from its operations over a specific period of time.
Profitability ratio is a category falling under financial ratios that are used by investors, bankers, financial institution, creditors and other stakeholders for evaluation of financial performance of the company in regards of annual profitability.
These ratios help them to assess how profitable an entity currently earns from using or managing the existing resources to generate profits and add value to its shareholders or owners.
For example, the gross profit margin is the ratio used to assess how efficiently the company manages its costs compared to its competitors or industry averages.
If the margin is high competitors’, it means that the company could generate high profit from 1 USD that it spends compare to competitors or industry averages.
Even though these ratios are importance for most of key stakeholders, that ratios themselves also have the limitation.
In this article, we will discuss the key importance and limitation of profitability ratio that might help analyst or users for their interpretation and usages.
But,
before heading to the key importance and limitation, let see the list and
formula of ratios first.
List and Formula:
The
following is the list of a few ratios that are included in the category of
profitability ratios:
Gross profit margin ratio = (Gross Profit / Revenue) * 100
Net profit margin ratio = (Net Profit / Revenue) * 100
Return on equity = (Profit after tax / Shareholder’s equity) * 100
Return on capital employed = Profit before interest and tax / (Total assets – current liabilities)
Return on assets = Profit before interest and tax / Total net assets
A high profitability ratio as compared to the previous year’s performance or the industry in general is an indication of improvement in the profits earned by the company.
On the contrary, though, a low profitability ratio as compared to the previous year’s or the industry in general is an indication of a reduction in profits earned in the current year.
Importance
of profitability ratios:
Here,
we will discuss the significance of profitability ratio in terms of each ratio
mentioned above.
- Gross profit margin is a measure of the profit earned on sales. It denotes the profit part of the total revenue earned after deducting the costs of goods sold. It is significantly important since the gross profit is what covers the admin and office costs and the dividends to be distributed to the shareholders. The higher the gross profit the more profitable the company is and is a good catch to invest in. As mention above, it is also used to assess the efficiency of cost management. If the calculation shows that the ratio is now, then the key areas to look or improve are purchasing as well as productions in terms of economy and effectiveness.
- The net profit margin is the final ratio that demonstrates the overall performance of a company. We could say that it is the most important ratio for the management since any disturbances in other ratios indirectly hit the net profit margin as well. For example, a low quick ratio may be because of low sales which would obviously lower the net profit margin as well. This ratio is important since it could help the company or investors to see where it could go wrong in the company’s current operating expenses. Maybe the interest expenses are too high due to the financing strategy that weighs more to loan rather than equity.
- Where the net profit margin is an important metric for the company itself, returns on equity are one of the most important ratios for the investors. It is a percentage of the earnings the shareholders get in return for the money invested in the company. The higher the ROE means the higher the dividends the shareholders will receive and hence, more investors are attracted.
- Returns on capital employed (ROCE) measures how efficiently the company uses its assets. It helps the management minimize inefficiencies by evaluating the ROCE ratio. The higher the ROCE as compared to other industries, the higher the efficiency in the production process of the company.
- Return on assets (ROA) is a measure of every dollar of income earned on every dollar of the asset owned by the company. It is similar to the ROCE and helps the management in managing the utilization of assets.
Limitations
of profitability ratios:
- The profitability ratios like, the net profit margin is not an “evergreen” ratio that can be used to compare profitability amongst various industries. For example, a tech-savvy company has a higher net profit margin compared to a bakery.
- The value of investment and profit can easily be manipulated to increase or decrease the profitability ratios as per their needs which can be misleading for the investors and stakeholders.
- The ratios are dependent on several calculations made behind each value reported on the financial statements. A material error or fraud in a line item will result in a miscalculated ratio which would be hazardous for investors and companies in the future.
- Ratios may also be high or good due to the chance factor and hence, shouldn’t be followed religiously. The context behind ratios must always be checked to confirm with the analysis.
Quick ratio
Overview:
The quick ratio is a financial ratio used to measure the short-term liquidity of a company where liquidity is defined as the ability of a firm to convert its most liquid assets into cash so that it could settle its current liabilities.
The quick ratio, also known as acid test ratio, measures how quickly a company can pay off its short-term debts and obligations through its near-cash (current) assets.
It
is calculated by dividing current assets excluding stock-in-hand by current
liabilities as shown below:
Here is the formula:
Quick ratio = (Cash& cash equivalent + Marketable security + Accounts receivable) / Current Liabilities
OR
Quick ratio = (Current assets – Inventory – Prepaid expenses) / Current liabilities
An
acid test ratio is a more aggressive method of measuring liquidity as compared
to the standard current ratio. The difference between both is inventory and
prepaid expenses which may take some time to turn into cash and may also have a
reduction in value.
For example, to convert inventories into cash, the company need to cash those inventories to customers. Not all of the sales are through cash in most of the business. The majority of them are sales on credit and the company does need more time to collect the payment.
The
current ratio includes all the current assets that can be converted to cash
within a year whereas quick ratio includes current assets that can be converted
to cash in 90 days only i.e. 3 months.
An optimal quick ratio is considered as 1:1 i.e. current liabilities = current assets. The ratio calculates every dollar of current assets available to pay off a dollar of current liability.
For example, if a current ratio of a company is 2:1, it means that it has $2 available to pay off every $1 liability. Similarly, a ratio of less than 1:1 signifies that the company doesn’t have enough liquid assets to pay off its short-term obligations.
In this article, we will discuss the key importance and limitation of quick ratio when it comes to the assessment of the liquidity of the entity:
Importance
of quick ratio:
- The quick ratio is one of the fastest and easiest ways of measuring a company’s liquidity. It is majorly used by creditors and lenders to evaluate an entity’s creditworthiness and timely payments before approving their application for the loan. Financial information to be used for calculation is easily obtained from financial statements.
- The quick ratio is an inflexible method of demonstrating the liquidity of a company. It excludes assets like inventory and prepaid expenses that take more than a year to turn into cash and may lose value as well during the time period. For example, a company that has inventory piled up due to low sales may have a high current ratio which would portray it as a liquid company even if it is running low on cash due to lower sales. Quick ratio ensures no such misleading information is portrayed regarding the liquidity of an entity.
- A quick ratio around the ideal value of 1:1 also signifies that the company is able to pay dividends on time which is considered a major pro since everyone wants money on time. Potential investors consider the quick ratio to make decisions about investing in the entity or not.
- A high quick ratio also implies that businesses are well prepared to adapt to any changes in business environments that attract investors as well.
- Measuring inventory involves judgment of management making it susceptible to human error. Quick ratio excludes inventory and hence, is a more precise unit of measure as compared to the current ratio.
Limitations of the quick ratio:
- One of the major cons of the quick ratio is that it can’t be used to compare various industries and can only be a metric of comparison for similar companies. A quick ratio is a mathematical value that provides no context of the assets and liabilities calculated.
- It doesn’t take into consideration the time frame of payments. For example, some of the accounts receivables included in current assets may become bad debts that will never be recovered in the future or may include receivable recovered after more than a year which actually has a negative impact on the liquidity of the company whereas the quick ratio portrays otherwise. Even the ratio is more than one but there is a high proportion of inventories compare to current assets that use for calculating the ratio then the decision that made based on this ratio is highly likely to be wrong.
- Where excluding inventory may be a pro it can also be a con for industries that have higher inventories. For example, a supermarket purchases millions of dollars of inventory by credit or by using cash and cash equivalents. In this case, the current liability balance would increase due to inventory purchased on credit and cash balance would be low which would cause a reduction in current assets resulting in an extremely low quick ratio. In such a case, justification should be made whether the inventories should be included or not.
Assets Turnover Ratio
Asset Turnover ratio is one of the important financial ratios that depicts how the company has been utilizing its asset to generate turnover or sales.
Asset Turnover ratio compares the net sales of the company with the total assets. It measures per rupee investment in assets used to generate amount of sales.
There are different versions of the ratio which depends on what type of asset is to be considered.
The formula to calculate this ratio is
Asset Turnover Ratio = Net Sales/ Average Total Assets
Here, Net sales is after sales return as well as sales discount. Average total assets is calculated after dividing the opening and closing balance of the assets by 2.
Various popular variations of this ratio include Fixed Asset Turnover Ratio, Current Assets Turnover Ratio among others.
A higher ratio indicates that assets are being utilized efficiently while the lower ratio reflects ineffective management of the assets.
Let’s discuss how the assets turnover ratio can be improved:
- Improve Debtors Collection: The slow pace of collection of accounts receivables increases the chance of lowering the sales. This reduces asset turnover ratio. By preparing and strictly adhering to a debtor’s policy, the company can actually improve the assets turnover ratio. This can be done by outsourcing the collection task to collection agency, hiring an employee overseeing accounts receivable or reducing the debtors credit period to at least industry norms.
- Improve Revenue: Improving revenue is easiest way to a healthy asset turnover ratio. The company needs to move its stock effectively and engage in promotional activities through advertisements. The company can also the examine the warehouse to ascertain whether there are slow moving stocks held in the warehouse. The company should find a way to move those slow-moving goods quickly.
- Liquidate Assets and Improve Efficiency: The company needs to have proper asset plan which deals with purchase and sale of assets strategically. Obsolete assets should be sold quickly as they are of no use to the contribution to sales and only makes the balance sheet look poor to the stakeholders. Assets frequently used should be regularly maintained in a scheduled manner while on the other hand, assets that are not frequently used, the company should arrive at strategic decision-making process whether to discard, replace or repair the assets. Bottleneck activities should be removed on the spot. If the company has delivery vehicles, the management should have a plan in place making sure that these vehicles leave the warehouse at full capacity delivery all the goods traveling the least. The management should also make effort to find various other ways to increase the efficiency of the asset.
- Take Assets on Lease: Well, this is not a fool proof way to improve assets turnover ration but on technical grounds, this can be used. If the company takes the assets on lease, the value of assets is not on balance sheet and is shown in Profit and Loss Account. The denominator i.e. of Average Assets in calculation of Assets Turnover Ratio is technically lower, thus, resulting in higher assets turnover ratio.
- Formulate Robust Inventory Management: The company should analyze how its stock move from company to its customer and know whether there are slow moving or fast-moving products of the company. The company can have slow or ineffective delivery system that can result in delay of service which in result will delay in collection period of accounts receivable. Hence, the company should computerize the process of order taking, inventory management and billing in order to improve and effectively manage cash flows of the company. This will eventually show up in sales numbers and improve the asset turnover ratio.
