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7.2.2. Exploring ROS

Gross profit percent, i.e. how much gross profit is made for every £100 of sales, represents the ability of the entity to add value to the resources it has consumed for the production of what has been sold. This result enables to investigate even more closely the accounting effects of the consumers' and clients' perceived quality of the entity's products or services (see above chapter 4 on Income statement). On the other hand, the effort that the entity has made, in order to create such a perception of quality, is reflected in the distribution, administrative and other operating costs. Hence, the valuation of these costs, too, as a percentage of the sales gives an effective comparative tool between different entities.

7.2.3. Exploring ATO

The turnover of the entity's non-current assets and the turnover of the entity's working capital,18 respectively 'calculated as sales divided by non-current assets' and 'sales divided by working capital', will give some insight on how effective the entity is, in comparison with its competitors, in using its non-current assets and how efficient it is in using its current assets. Respectively, the higher the non-current assets turnover, the more effective the entity is, as it is able to obtain more sales from those assets; the higher the working capital turnover, the more efficient the entity is in making its current assets flow at a fast pace.

The sequence of ratios linked in a sort of cascade as explained so far is called the 'pyramid of ratios', as illustrated in figure 8.

the pyramid of ratios

Figure 8 - the pyramid of ratios

7.2.4. Solidity and solvency

The conceptual difference between ROE and ROCE is explained above, in terms of purposes and use of the two ratios. However, in managerial terms, there is link between the two ratios; the difference in value between the two ratios is originated by the amount of debt exposure of the entity. If the value of the equity is kept constant, increasing long term liabilities implies an increase of the capital employed. As a consequence, the entity can count on more resources with which to produce more operating profit, at a pace measured by ROCE. If the additional finance cost created by the additional long term liability does not exceed the increase of operating profit, the net profit will increase, too, hence improving the ROE. See figure 8.

The amount of long term liabilities in respect of the amount of equity is called Gearing19 and is measured with the following formula:

Gearing = long term liabilities / equity

the gearing effect on the size of an entity

Figure 8 - the gearing effect on the size of an entity

It might seem, as a corollary of the above explanation, that the higher the gearing is, the better it is for the owners of the business, because of its multiplier effect of the profitability. However, the effect of high gearing is also that the risk of the entity increases, as the entity is committed to more and more debt to be paid back (principal) and paid for (interest). Should the ROCE decline, the entity might find itself over-exposed towards its lenders and using more resources than it is creating, i.e. reducing the owners' wealth instead of maximizing it.

In fact, as a general rule, there is a point of the expansion of any entity where further expansion will result in reduction of ROCE, because less profitable markets will have to be targeted and because the costs of coordination of an ever expanding entity will increase more than proportionally of the benefits they create. Equally, there is a point of a gearing-based expansion, beyond which the cost of financing the expansion will be more than proportional to the amount of new raised capital, which is due to the increasing risk that the lenders attach to the entity. Hence, there is a point in the way of an ever expanding entity, where expanding is no longer logical, as its cost overcomes its benefit. A wise management must identify this point and stop exposing the entity to new debt well ahead of that point, to account for the risk of unwillingly drifting towards it, should the profitability slow down at a faster than expected pace or the cost of debt increase at a faster than expected rate. See figure 9.

the risk associated with gearing and the 'danger zone'

Figure 9 - the risk associated with gearing and the 'danger zone'

You will be able to assess the appropriateness of your chosen entity's gearing by comparing its gearing with the average gearing of its competitors and the average in the industry. Also, other ratios will complement this information: one of them is the 'interest cover', for example, which shows how many times the operating profit is larger than the cost of financing the entity, with the following formula,

Interest cover = operating profit / finance costs

You can choose to consider the 'net finance cost', i.e. finance cost deducted of finance income or purely the 'finance cost, based on whether the finance income is integral part of the normal financing activity of the entity or derives from an exceptional event.

 
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