PRETAX PROFIT/CAPITAL EMPLOYED revised ratio.
A while ago I posted my suggestion regarding the make-up and use of the PRETAX PROFIT/CAPITAL EMPLOYED financial ratio in the following post ....
Message 24373885
Since then my good friend and mentor, Dr. Karl Posel, D.Sc., did a re-think on the CAPITAL EMPLOYED component of the ratio and decided that an amendment was required.
The way he sees it, one should deduct the Net Income amount, that has been earned in the latest 12 month period, from the Capital Employed amount for that same 12 month period.
The reason being that the Net Income amount on the latest Income Statement was generated from a Capital Employed amount that did not include that latest Net Income amount. However, that Net Income amount will be included in the “Reserves” on the latest Balance Sheet, which is why it must now be deducted.
I have therefore revised the following section of my previous post. I’ve put the changes in italics ....
PRETAX PROFIT/CAPITAL EMPLOYED :-
"Shareholder’s Equity" and "Net Income" could be replaced by other components of the Income Statement and Balance Sheet. And these other components could be less susceptible to "distortions".
Investors may want to consider a "Returns Ratio" based on "Pre-Tax Profit" from the Income Statement, and "Capital Employed" from the Balance Sheet.
I refer here, primarily, to Industrial type companies.
By using "Pre-Tax Profit" we do away with the aspect of possible "Tax Credits", and any non-taxable "Extra-Ordinary Items". One then only has to ensure that one is not including taxable "Extra-Ordinary Items".
PRETAX PROFIT is found in an Industrial company’s Income Statement just above the line that shows "TAXATION".
CAPITAL EMPLOYED is obtained by adding together the following items found in an Industrial company’s Balance Sheet :-
Share Capital + Reserves + Long Term Debt + Deferred Tax = CAPITAL EMPLOYED.
How that Capital has been "EMPLOYED" is defined as EMPLOYMENT OF CAPITAL, and is equal to :-
Fixed Assets + Current Assets – Current Liabilities = EMPLOYMENT OF CAPITAL.
Because one half of a Balance Sheet must equal the other half, i.e. "Balance", we have ...
CAPITAL EMPLOYED = EMPLOYMENT OF CAPITAL.
IMO the quickest way to get "Capital Employed" from the Balance Sheets of USA companies is to subtract "Current Liabilities" from "Total Assets". In other words …
TOTAL ASSETS – CURRENT LIABILITIES = EMPLOYMENT OF CAPITAL = CAPITAL EMPLOYED
By using "Capital Employed" one is incorporating that amount of Capital that a company has to "Employ".
However, to obtain that amount of CAPITAL EMPLOYED which was used during the latest 12 month period to generate the NET INCOME for that 12 month period, one must deduct the latest 12 month amount of NET INCOME, found in the Income Statement, from the latest CAPITAL EMPLOYED amount in the latest Balance Sheet.
The "Long Term Debt" and any "Deferred Tax" amounts are not part of the "Shareholder’s Equity" that forms the ROE denominator, but yet they are valid amounts of Capital that a company has at its disposal.
If you were to refer to the way UK companies present their Balance Sheets you will see that one half of their Balance Sheet consists of the "Capital Employed" I referred to above, while the other half consists of the "Employment of Capital”.
So my suggestion is to use the following percentage ratio, instead of ROE, and preferably to have it as big as possible :-
(PRETAX PROFIT/(TOTAL ASSETS – CURRENT LIABILITIES - NET INCOME))x100, which is identical to ...
(PRETAX PROFIT/(CAPITAL EMPLOYED – NET INCOME))x100, for the latest 12 month period. |
