Return on Capital Employed (ROCE) is the main measure to look at when evaluating the financial performance of a business. Aside from measuring the profitability of a business, ROCE also measures how effectively the capital was used. Basically, if ROCE is not high enough, it means something is not quite right.
ROCE is the measure to look at because it emphasises the connection between inputs and outputs of the business. The inputs are found in the balance sheet, such as stock, creditors, plant and equipment, etc. The outputs are found in the profit and loss statement, such as margin, sales and expenses.
If your ROCE is not high enough, what are the important things you should look at? Here they are:
What is the percentage that your pre-tax profit bears to your sales? To find out, look at EBIT or earnings (profit) before interest and tax. The higher the number is the better. However, as a guide a profitability percentage of below 5% is too small.
Gross profit margin is one of the main influencers of your profitability percentage. You are not generating enough margin on your sales if your profitability is too low. It is the custom of some companies to cut margin in an effort to make more sales. This can be harmful, depending on the phase of the business cycle you are in.
Scale can be an issue for small businesses because of the fixed costs they incur just by opening their doors. Bottom line, businesses are likely to operate at loss until you attain a critical mass. When a breakeven point is reached, then that’s the time to pay attention on growing margin in order to earn more profit.
If you analyse the items above and you still see a problem, then you need to cut your expenses. Focusing on margin will usually produce the best results in increasing profitability, but businesses sometimes allow expenses to go unchecked.
5. Working capital
The first four items are included in the profit and loss statement. Working capital and the remaining items are considered as inputs to the business. Working capital is a vital item, particularly for fast-growing companies.
6. Surplus assets
Accumulated assets that are no longer useful represent real cash – you just need to unload them. Find out if your business has a “lazy” balance sheet by checking if you have surplus plant and equipment, extra stock holdings or failed debtor management. Do something about your lazy balance sheet to improve business performance.
7. Small changes
Sometimes making small changes is enough to improve the financial performance of a business. So concentrate on making small changes on all 6 items above.
ROCE directs business value. Focus on improving ROCE if you are aiming to raise the value of your business.
Seek the expertise of professionals to improve the profitability of your business. Talk with your accountant or call PJS Accountants. We offer accounting and other booking services to individuals and companies, big and small. Allow our team to evaluate your financial situation and advise you on the right measures to boost profits. Contact PJS Accountants for enquiries.