Financial Ratio Analysis - Review of ROCE and the Pyramid of Ratios

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

Pyramid of Ratios

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

and

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 * Turnover
Equity Shareholders' Funds Turnover Equity Shareholders' Funds

Giving

ROCE = Profit for the Year = Profit for the Year
Equity Shareholders' Funds Equity Shareholders' Funds

There, and you thought maths was a nightmare!

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