Review of ROCE and the Pyramid of Ratios
Return on Capital Employed Revisited
There is a ratio analysis approach called the du Pont Technique or the Pyramid of Ratios Technique. We are not going to look at the whole pyramid technique and there is nothing new in it in terms of the ratios we might use; but it does contain an interesting feature.
Here are the top two levels of the pyramid
ROCE is called the Primary Ratio because it is at the top of this pyramid. Moreover, every ratio in this pyramid feeds up into this primary ratio, along these lines:
ROCE = Profit for the year margin x Capital Employed Turnover
These relationships are very useful and we can see this better when we write the formulae out in full:
|Return on Capital Employed (ROCE)||=||Profit for the Year||* 100|
|Equity Shareholders' Funds|
|ROCE||=||Profit for the Year Margin||=||Profit for the Year||* Capital Employed Turnover||=||Turnover|
|Turnover||Equity Shareholders' Funds|
Notice how we use the name capital employed for the equity shareholders' funds - helpful or what? It's true though. A business's capital employed is also equal to its net assets.
When we put the profit margin and capital employed turnover ratios together and cancel, like we do in maths, we get the ROCE.
Put it all together and you will see what we're driving at!
|Profit for the Year||=||Profit for the Year||*||Turnover|
|Equity Shareholders' Funds||Turnover||Equity Shareholders' Funds|
When we cancel the common elements from the profit margin and capital employed turnover ratios, we get the ROCE ratio ...
|Profit for the Year||=||Profit for the Year||*||
|Equity Shareholders' Funds||
||Equity Shareholders' Funds|
|ROCE||=||Profit for the Year||=||Profit for the Year|
|Equity Shareholders' Funds||Equity Shareholders' Funds|
There, and you thought maths was a nightmare!