Is the 16.1% ROCE a step change or an accounting artefact?
Northgate Co's draft results for the year to 31 March 20X6 show revenue of $61.0m (20X5: $50.0m), operating profit of $9.8m (20X5: $7.0m) and capital employed at the year end of $60.8m (20X5: $56.5m), giving ROCE of 16.1% against 12.4%. The CEO's board paper describes this as 'a step change in operating efficiency'. You obtain the following from the accounts: (i) a $5.0m profit on the disposal of surplus land is included in operating profit, and the $14.0m proceeds are still held in cash at the year end, not yet reinvested; (ii) Northgate acquired a competitor on 1 October 20X5, which contributed $6.0m of revenue and $1.2m of operating profit for the six months of ownership; (iii) a one-off legal settlement of $0.9m was charged to operating profit. No other adjustments are proposed.
1. Recompute revenue growth and ROCE on a like-for-like basis and assess whether the CEO's claim is supportable.
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Revenue growth
- Reported: 61.0 / 50.0 − 1 = +22.0%.
- Strip out the acquisition's $6.0m: organic revenue = $55.0m, growth = +10.0%. Half of the reported growth is bought, not earned.
Operating profit
- Reported: $9.8m
- Less profit on land disposal: (5.0)
- Less acquisition contribution: (1.2)
- Add back one-off legal settlement: 0.9
- Like-for-like operating profit: $4.5m against $7.0m last year - a fall of 35.7%.
Capital employed / ROCE
- Reported: 9.8 / 60.8 = 16.1%.
- Unadjusted denominator: 4.5 / 60.8 = 7.4%.
- Removing the $14.0m of uninvested disposal proceeds (they are not yet generating a return): 4.5 / 46.8 = 9.6%.
Conclusion: under every like-for-like basis ROCE is below the prior year's 12.4%. The rise in the headline ratio is driven by a disposal gain, a bought-in profit stream and an inflated capital base, not by efficiency. The claim is not supportable and the board paper should be corrected before it is circulated. Presenting both adjusted figures is better than choosing one, because the choice of denominator treatment is a judgement that a reader should be able to see.
2. Explain the judgement you had to exercise in deciding how to treat the $14.0m of disposal proceeds, and state which presentation you would put in the board pack and why.
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The judgement: ROCE compares profit with the capital employed to generate it. Cash from a disposal is capital that has been removed from operations pending reinvestment, so leaving it in the denominator understates the return actually being earned by the operating business - and will flatter the ratio next year once the cash is spent. But removing it also removes it from the prior-year comparison, which was not restated.
Decision: present both: 7.4% (total capital employed, comparable with last year's 12.4% as reported) and 9.6% (operating capital employed, excluding uninvested proceeds), with a one-line note explaining the difference. Neither is 'wrong'; a single figure would hide the judgement.
Supporting analysis to include in the pack:
- State clearly that both are below 12.4%, so the direction of travel is the same either way.
- Flag that the proceeds will be reinvested, so next year's ROCE will fall unless the reinvested capital earns at least 12.4%.
- Avoid adjusting the prior year for the legal settlement, since no equivalent figure is available; note it as a limitation.
3. Give two further pieces of information you would request before signing off the analysis, and explain what each would change.
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- Monthly or quarterly results, and the acquisition's full-year run-rate. A six-month contribution of $6.0m revenue may be seasonal; annualising it as $12.0m assumes no seasonality. If the acquired business is second-half weighted, the true acquired revenue could be materially higher and organic growth lower still.
- Segmental revenue and gross margin by product line. Reported revenue growth of 10% on a like-for-like basis tells us nothing about whether it came from volume or price. If it came from a price rise following a competitor's exit, it is not repeatable and the 'step change' narrative is even weaker; if from volume, it may be.
- Cash conversion and working capital (receivables days, inventory days). Profit growth without cash conversion would indicate that the reported margin improvement is being funded by looser credit terms or channel stuffing.
- Whether any of the acquisition consideration is contingent and therefore a future charge to profit, which would depress next year's ROCE further.
Any one of these could reverse the conclusion, which is why the board paper should present the analysis as provisional.