Sustainability of Business-ROCE(Return on Capital Employed) & new ROCE(Return on Climate & Environment)-an Integrated approach

 

Sustainability of Business-ROCE(Return on Capital Employed) & new ROCE(Return on Climate & Environment)-an Integrated approach

 

ROCE(Return on Capital Employed), according to Warren Buffet, is an important Financial Ratio that is used for measuring the combined effect of Profitability of the Business and the Productivity of the Business assets which can sustain its value. 

Profitability is measured in terms of  Return on Sales and Productivity is measured in terms of how well the Assets of the Business are put to use by looking at Assets Turnover.

(1)The formula used for calculating Return on sales is PBIT less Tax/Net Sales.

(2)The formula for calculating Turnover on Assets is Net Sales/(Net Fixed Assets+Net Current Assets i.e(Current Assets-Current Liabilities)

(3) the formula for calculating Return on Capital Employed(ROCE) is obtained by Multiplying (1)X(2)- (calculated for every year separately in the example given below)

The following is a real example of a trend of ROCE of a Business over the years ,that has three Verticals:

Belts, Oilseals and Engineering.The composite business is called Polymer.

 

Now for this Business ,an analysis is done and the ways of how to improve the ROCE of this Business have been identified. This is as follows:

                               

                            How to Improve ROCE of the Business

 This ROCE improvement Plan can be built through Balanced Scorecard Methodology.(The Balanced Scorecard;Measures that drive Performance-HBR-1992 by Dr.Robert S.Kaplan and David P.Norton )

EVA Ratio-"Economic Value Added"(Stern Value Management) of the Business, which is the Economic Profit of the Business can also be considered as the Ultimate Financial goal of a Business . The EVA is NOPAT(Net Operating Profit After Tax)- (Invested Capital*WACC) where Invested Capital includes both Equity & Debt and WACC is Weighted Average Cost of Invested Capital. In this WACC, the cost of Debt i.e Borrowed capital is calculated Net of Taxes, where the local Income/Corporate Tax policies allow deduction for the Interest paid on Borrowed Capital and the Dividend payable/expected by Shareholders is considered as the Cost of Equity.When EVA is integrated with Value-Based Management that becomes the key to Sustainable Value Creation by any Organisation(Stern Value Management-1993- “The Real key to Creating Wealth”).

 

A sample of Strategy Map developed with EVA &ROCE Ratios being tracked on Quarterly basis by comparing Actuals vs Target ,under Balanced Scorecard Methodology for a Co. in India is given below:

 

The benefits of drawing out a Strategy Map like this on Financial perspective built on Financial Ratios at the pinnacle, and Customer ,Operational and Learning & Growth perspectives are many due to interplay of cross-functional interactions and improvements flowing through the entire organisation. When this happens the organisation functions as a one whole being with all its parts working in Sync, Synergistic & Sustainable ways.

On an external environment, it is like all the players of a Team planning a carefully laid out Strategy in a tournament for winning a World cup in Soccer or Cricket!!

Since, the world has already moved into Sustainable Business models with 3Ps as the focus-Profit, People and Planet, and is now rapidly moving into Sustainable business through harmonious assimilation of Environment,Social and Governance values into Business Sustainability(The Investor Revolution-HBR-May-june 2019 bySvetlena Klimenko and Robert G.Eccles).

Now, we have reached a point where we need to integrate traditional ROCE-Return on Capital Employed with the new Return on Climate and Environment.  ESG reporting in India started in 2009 with the Ministry of Corporate Affairs (MCA) issuing the Voluntary Guidelines on Corporate Social Responsibility, since then the reporting landscape has come a long way with the introduction of Business Responsibility Reporting (BRR), Corporate Social Responsibility (CSR), IR, National Guidelines on Responsible Business Conduct (NGRBC) and the newly introduced Business Responsibility and Sustainability Report (BRSR) (introduced through a SEBI circular dated 10th May 2021).

World Economic forum on its part has come out with set of 21 core and 34 widened metrics and disclosures in its report “Measuring Stakeholder Capitalism:Towards Common Metrics and Consistent Rporting of Sustainable Value Creation “(WEF report,2020), as an extension of Stakeholder Capitalism Metrics standing on 4 pillars-People,Planet,Prosperity and Principles of Governance.

For future growth of the Sustainable Business Value Creation the integration of these metrics with Financial Metrics, is sine-qua-non.