Yet another ROCE thread

[Jinnentonix]

Hi everyone.

I've been trying to get my head around ROCE and there is a part in the textbook which I don't fully understand.

It says that a variation to ROCE is to include overdrafts and sets out the following:

If an overdraft is not included in the denominator, any interest payable on the overdraft should ideally be deducted from the numerator. Where an overdraft is included in the denominator, any interest payable on the overdraft should appear in the numerator.

I thought that:

1. where overdraft IS NOT included, you need to include interest payable in the numerator (which would reduce the numerator by virtue of it being a negative number); and
2. where overdraft IS included, you do not need to include interest payable in the numerator.

My reasoning, I think, is consistent with how the two ratios for ROCE are calculated in the first place (the second ratio excluded long-term debt but included the interest payable on it vis-a-vis the first ratio).

That said, I am happy to stand corrected if I'm wrong and I'm having trouble distinguishing between the words "deducted" and "appear" in the two sentences quoted above.

Thanks for any clarification.

 

[Bharti Singla]

I think both the things i.e.The two formulas given of ROCE and the para of overdraft given under heading 'variations' are conveying same meaning.

In the formulas, the second formula says that if we don't include long-term debt in denominator, it means we are considering the return generated by OTHER INVESTORS only(except these long-term debts) . So we have to pay interest to long-term debts first, only after that we will get the profit actually generated by other investors ( like. shareholders). Thats why we deduct interest in numerator. It is PROFIT BEFORE TAX means profit in which interest have been deducted but not tax. (They are not including the interest what you are getting wrong here).

Similarly, the para is saying that if an overdraft is NOT included in denominator, any interest on it will be deducted from numerator.

Hope this helps.
Thanks

 

[Jinnentonix]

Thanks for the explanation.

Correct me if I'm wrong, but it looks like the first formula uses pre-tax income available for distribution to both lenders and shareholders whilst the second formula takes pre-tax income available to shareholders only.

Be that as it may, the wording regarding overdrafts still confuses me. Is it saying that if overdraft is included in the first formula (in addition to equity and long-term liabilities):

• interest payable on the overdraft is not subtracted from the EBIT figure in the numerator; and
• thus the numerator would not have changed at all when compared to the first formula?

Appreciate any further clarification.

 

[Bharti Singla]

You are correct in this result:

Correct me if I'm wrong, but it looks like the first formula uses pre-tax income company available for distribution to both lenders and shareholders whilst the second formula takes pre-tax income available to shareholders only.

Now, if we look at first formula here the numerator figure is the 'Profit available to lenders and shareholders'. And the overdraft is not included in denominator here. I think it means the interest on overdraft is already deducted from the profit figure given. i.e. the interest on overdraft has been deducted but interest on long term debts is not deducted. And if we INCLUDE overdraft in denominator now, then we have to add back the interest on overdraft. Thats why they are saying that the interest on overdraft should APPEAR in the numerator. It simply means that the profit figure will include interest on overdraft in numerator.(I.e.Interest on overdraft, interest on debts and tax all are not deducted from profit).