Notes: ROCE, Waldo Manufacturing, and Liquidity Ratios

Return on capital employed (ROCE)

  • ROCE is the profitability measure that relates profit to the capital used to generate it.
  • Key focus: profit before interest and tax (PBIT) relative to the capital employed base.
  • Formula:
    ROCE=PBITCapital Employed×100%ROCE = \frac{PBIT}{Capital\ Employed} \times 100\%
  • Denominator: Capital Employed
    • Common definitions:
    • Equity + Non-current liabilities (long-term funding)
    • Alternative widely used form: Total assets − Current liabilities
    • Transcript note shows some ambiguity during a quick discussion; the standard teaching is: Capital Employed = Equity + Non-current Liabilities.
  • Interpretation and goals:
    • A higher ROCE means more efficient use of capital to generate profit.
    • Compare ROCE across time (trends) and against industry benchmarks/competitors.
    • An increasing ROCE over time or relative to peers is generally favorable for investors.
  • How to improve ROCE (three broad approaches):
    • Increase profitability (e.g., boost sales, reduce cost of production, manage expenses).
    • Improve asset efficiency (dispose of unused/obsolete/unproductive assets).
    • Optimize the asset base to reduce capital employed while maintaining or increasing profit.
  • Worked example from the transcript:
    • Given data (example): PBIT = 3,565,000; Capital Employed = 7,000,000.
    • Calculation:
      ROCE=3,565,0007,000,000×100%=50.93%≈51%ROCE = \frac{3{,}565{,}000}{7{,}000{,}000} \times 100\% = 50.93\% \approx 51\%
    • Interpretation: ~51% ROCE for the period; high relative to some benchmarks but must be compared to industry averages/competitors and past periods.
  • Discussion notes:
    • A sharp increase in sales with a margin squeeze could still yield a high ROCE if capital employed is stable or reduced.
    • Benchmarking against industry averages or competitors is crucial for interpretation.

Waldo Manufacturing PLC: context and key ideas

  • Company profile: public limited, premium lighting fixtures; January 2020 shares increased from 1,000,000 to 1,200,000 (200,000 new shares at $50).
  • Financing action: issued new equity and borrowed 20,000,000 via a bank loan.
  • Qualitative note: employee reaction to a shift in processes was largely supportive but some concern about impact on profit-sharing bonuses.
  • Focus of the case: to interpret financial data and forecast using provided tables (Table Four: historical data; Table Five: forecasts).
  • Part A tasks (summary): comment on sales revenue data; comment on gross profit margin and profit margin; use Table Five to forecast 2022 sales; compute forecasted per-unit contribution; compute forecasted profit margin for 2022.
  • Contribution per unit (definition):
    • Contribution per unit = Selling price per unit − Variable cost per unit.
    • Example given: selling price = $1,000; variable cost per unit = $600; Contribution = 400400 per unit.
  • Important to show working for 2-mark questions and to contextualize commentary to the data provided (e.g., changes in revenue vs. margins).
  • Mass customization note: a qualitative cue that changes in production could affect margins; not covered in depth in the current module.

Contribution concept and 2022 forecast approach (Waldo Manufacturing)

  • What is contribution?
    • The portion of revenue that contributes to fixed costs and profit after variable costs are covered.
    • Formula (per unit):
      Contribution=Selling Price per Unit−Variable Cost per UnitContribution = Selling\ Price\ per\ Unit - Variable\ Cost\ per\ Unit
  • Forecast steps (as described in the transcript):
    • Step 1: Forecast revenue for 2022 using the stated growth rate: if revenue in 2021 is $R{2021}$ and growth is 20%, then R</em>2022=R<em>2021×(1+0.20)=R</em>1×1.20R</em>{2022} = R<em>{2021} \times (1 + 0.20) = R</em>{1} \times 1.20
    • Step 2: Per-unit contribution with given unit data (e.g., price $1{,}000$, variable cost $600$):
      Contribution per unit=1000−600=400Contribution\ per\ unit = 1000 - 600 = 400
    • Step 3: Forecasted total contribution for 2022:
    • If the forecasted revenue is $R{2022}$ and price per unit is $1000$, then units forecasted ≈ $R{2022}/1000$.
    • Total forecasted contribution ≈ $(R{2022}/1000) \times 400 = 0.4 \times R{2022}$.
    • Step 4: Forecasted fixed costs: assumed to remain as in the prior period unless stated otherwise.
    • Step 5: Forecasted PBIT (for 2022):
      PBIT<em>2022=R</em>2022−VariableCosts<em>2022−FixedCostsPBIT<em>{2022} = R</em>{2022} - VariableCosts<em>{2022} - FixedCosts where VariableCosts</em>2022=0.60×R2022VariableCosts</em>{2022} = 0.60 \times R_{2022}
      (since variable cost per unit is $600 on a $1,000 selling price).
    • Step 6: Forecasted profit margin for 2022:
      Profit Margin<em>2022=PBIT</em>2022R2022×100%Profit\ Margin<em>{2022} = \frac{PBIT</em>{2022}}{R_{2022}} \times 100\%
  • Alternative calculation approach (if preferred): compute variable costs directly from per-unit data and total units:
    • If units = $N = R{2022}/1000$, then VariableCosts</em>2022=600imesNVariableCosts</em>{2022} = 600 imes N
  • Example interpretation notes from lecturer:
    • It is acceptable to present just the numeric answer for a 1-mark contribution question (e.g., 400) without showing lengthy working.
    • For more complex prompts (e.g., 2-mark questions), show the method clearly to access the marks, particularly when deriving revenue, costs, and margins.

Liquidity and liquidity ratios (intro)

  • Core idea: liquidity measures assess a business’s ability to meet short-term obligations as they fall due.
  • Why liquidity matters: cash is king; insufficient liquidity can lead to insolvency or bankruptcy even if the business is profitable.
  • Quick intuition from the discussion:
    • Cash and other liquid assets allow you to settle bills promptly (utilities, wages, suppliers, taxes).
    • Non-current assets (e.g., property) are often not easily convertible to cash on short notice.
  • Common liquidity ratios (to be covered in detail next):
    • Current ratio (CR):
      Current Ratio=Current AssetsCurrent LiabilitiesCurrent\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}
    • Quick asset ratio (a.k.a. acid-test ratio):
      Quick Asset Ratio=Current Assets−InventoryCurrent LiabilitiesQuick\ Asset\ Ratio = \frac{Current\ Assets - Inventory}{Current\ Liabilities}
      or equivalently, Cash+Debtors+Short−term InvestmentsCurrent Liabilities\frac{Cash + Debtors + Short-term\ Investments}{Current\ Liabilities}
  • Most liquid asset: cash. Other liquid assets include debtors (accounts receivable) and short-term investments; inventory is less liquid for some businesses and is excluded in the quick ratio.
  • Example given in the discussion:
    • If Current Assets = $25,000,000 and Current Liabilities = $15,000,000, then
      Current Ratio=25,000,00015,000,000=1.67Current\ Ratio = \frac{25{,}000{,}000}{15{,}000{,}000} = 1.67
    • Interpretation: 1.67:1 indicates more current assets than current liabilities; whether this is good depends on industry norms and asset mix.
  • How to interpret liquidity levels:
    • A ratio just above 1 suggests sufficient liquidity but may be tight depending on cash flow timing.
    • A ratio far above 1 may indicate underutilized assets or excessive working capital.
    • A ratio well below 1 signals potential liquidity problems.

Debtors, creditors, and working capital flows

  • Trade creditors: suppliers to whom the business owes money (e.g., Bunnings giving credit terms);
    • Example concept: extending payment terms (e.g., from 30 to 90 days) Improves liquidity in the short term by keeping cash longer, but can strain suppliers and relationships.
  • Trade debtors: customers who owe money to the business (receivables), representing expected future cash inflows.
  • Impact of terms on liquidity:
    • Extending supplier credit increases current liabilities but can preserve cash in the short term.
    • Shortening collection periods improves liquidity by converting receivables to cash faster.
  • Settlement timing:
    • Settlements for major assets (e.g., real estate) can be 30–90 days or longer; cash is not instantly available on acquisition or disposal.
  • Practical reminder from the lecture: maintain a balance between negotiating favorable terms and sustaining supplier/customer relationships; too aggressive changes can disrupt operations.

How to improve the current ratio (and liquidity in practice)

  • Increase current assets or reduce current liabilities.
  • Practical actions discussed:
    • Extend trade credit periods with suppliers (e.g., pay later) to keep cash in the business longer.
    • Improve cash collections from debtors (tighten credit policy, offer discounts for early payment).
    • Convert non-current assets to cash (e.g., sell idle equipment or slow-moving inventory).
    • Pay down some current liabilities with available cash to reduce denominator.
    • Encourage customers to pay in cash or upfront when possible.
    • Reduce reliance on short-term debt; refinance or restructure debt where feasible to lower current liabilities.
  • Remember the caveat: liquidity measures are context-specific; always compare to industry norms and the company’s asset structure.

Quick reference: formulae to remember (LaTeX)

  • ROCE:
    ROCE=PBITCapital Employed×100%ROCE = \frac{PBIT}{Capital\ Employed} \times 100\%
  • Capital Employed (definitions):
    • Capital Employed=Equity+Non−current LiabilitiesCapital\ Employed = Equity + Non{-}current\ Liabilities
    • Capital Employed=Total Assets−Current LiabilitiesCapital\ Employed = Total\ Assets - Current\ Liabilities
  • Contribution per unit:
    Contribution=Selling Price per Unit−Variable Cost per UnitContribution = Selling\ Price\ per\ Unit - Variable\ Cost\ per\ Unit
  • Forecasted revenue (growth):
    Revenue<em>2022=Revenue</em>2021×(1+g)<br/>Revenue<em>{2022} = Revenue</em>{2021} \times (1 + g)<br /> with growth g (e.g., g = 0.20 for 20%)
  • Variable costs (as a share of revenue when per-unit data is given):
    • If price per unit = $P$ and variable cost per unit = $VC$, then
      VariableCosts=VC×RevenueP=(VC/P)×RevenueVariableCosts = VC \times \frac{Revenue}{P} = (VC/P) \times Revenue
    • For $P=1000$, $VC=600$, this is 0.60 × Revenue.
  • Profit margin (net):
    Profit Margin=Net ProfitSales×100%Profit\ Margin = \frac{Net\ Profit}{Sales} \times 100\%
  • Current ratio:
    Current Ratio=Current AssetsCurrent LiabilitiesCurrent\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}
  • Quick ratio (acid-test):
    Quick Ratio=Current Assets−InventoryCurrent LiabilitiesQuick\ Ratio = \frac{Current\ Assets - Inventory}{Current\ Liabilities}

Quick practical recap

  • ROCE is a key gauge of how well a company uses its capital to generate profits; compare across periods and with peers.
  • Capital Employed is the funding that supports operations (equity + non-current liabilities), not simply all assets; understand the precise definition used by your lecturer.
  • When forecasting: clearly state assumptions (growth rates, unit prices, variable costs, fixed costs) and show steps for each calculation to secure marks.
  • Liquidity matters for solvency: keep enough cash/quick assets to cover short-term obligations; use current and quick ratios to assess this, and adjust working capital components accordingly.
  • Debtors vs. creditors explain why timing of cash inflows and outflows matters for liquidity; negotiating terms can be a strategic tool, but with attention to supplier relationships and cash flow realism.