The point of investing is to get the best returns possible on your money. So it makes sense to buy companies that make high returns on the money they invest themselves those who make a decent Return on Capital Employed' (ROCE) as long as you don't have to pay too much for the shares.
So how do you calculate ROCE? This is where the balance sheet comes in. On one side, a balance sheet shows what a company owns (its assets). On the other, it shows what it owes to others (its liabilities), plus the equity' invested by shareholders. The two always balance hence the name.
To understand this, look at your own personal balance sheet. Say you buy a house for £300,000. You have a 90% mortgage (£270,000) and £30,000 of your own money (your equity). So the house (the asset) is balanced by the mortgage (the liability) plus your equity.
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A worked example
Let's look at how to read a typical balance sheet. I'll use brewer and pub owner Greene King as an example. The numbers are from its latest annual report.
You start by taking the value of all its assets (total assets') its pubs, brewery, stocks of food and drink, etc and deduct items such as cash and what are known as non-interest bearing current liabilities (NIBCL). These include supplier bills and taxes that have been taken off profits, but have not been paid yet. These items are deducted because they are a form of free loan for a business.
If bills had to be paid immediately, the company would have to stump up more money and have more investment in the business. You get the NIBCL figure by taking the number for current liabilities from the balance sheet and take away any short-term borrowings or bank overdrafts (which charge interest). You can now work out how much a company has invested in its business.
The same number can also be found by looking at how a company is financed. You add up the money received from shareholders (equity' or shareholders' funds'), net borrowings (debt less cash) and other long-term liabilities, such as tax, provisions for liabilities and pension liabilities.
But whichever method you use, Greene King has invested just over £2.8bn in its business.
Remember that balance sheets are a snapshot of a company's finances on one day at the end of a year. If a company invests a lot of money near the end of the year, all that money will be on the balance sheet, but very little sales or profits will be earned from it.
So, when using capital employed, it's best to divide the starting and ending figures to get an average.
Putting the number to good use
Knowing how much money a company has invested is very useful. Calculating ROCE shows you if the money is being well spent. You simply take operating profit (£248.2m in this case) and divide by capital employed (£2.8bn). That gives an ROCE of 8.7%.
You can then compare this to the returns made by other companies in the sector, or even to other assets, to get an idea of whether the your money is being put to good use.
You can also work out what value of sales is being generated per £1 invested. This is known as the capital turnover ratio and is calculated by dividing sales by capital employed. This can give you a good insight into whether a company is on an upwards or downwards trend.
Falling capital turnover may be a warning sign of lower future returns, if profit margins fall as well.
As with all calculations, it's best to do them for a period of at least five years to get a real feel for whether a trend is developing. I've looked at one particularly successful company below.
Can Rotork continue to deliver?
|Capital employed (A)||£118m||£114m||£131m||£219m||£258m|
|Operating profit (C)||£76m||£92m||£99m||£116m||£132m|
|Profit margin (D)||23.7%||26.1%||26.1%||25.9%||25.8%|
|Capital turnover E =(B/A)||£2.71||£3.10||£2.90||£2.04||£1.98|
|End of year figures used for capital employed|
Rotork (LSE: ROR) has been a great investment. Its shares have tripled in value over the last five years. That's because it has been able to grow profits, while maintaining very high returns on capital employed. But will that be the case in the future?
As you can see, profit margins have stayed high, but there has been a big increase in the money invested since 2010 as Rotork has been buying other companies. This has seen capital turnover fall.
In 2010, it was making £3.10 in sales for every £1 it invested. Last year it made £1.98. Its financial performance is still very impressive, but any further deterioration in this trend may be a warning sign.
Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for Moneyweek in 2010.
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