Question

3. A student comes up with a new ratio to measure performance: she calls it profit
ratio: ROCE/WACC
o What does it measure? Interpret it.
o Do you consider it a good performance measure? Explain.
o Can you think of a better name for it? Why?

Answer 1

# ROCE stands for return on capital employed. This is the accounting, valuation ratio used to measure the profitability of the company after taking into account all of its capital employed by the company.

ROCE= (EBIT÷ capital employed)*100

Where as WACC stands for weighted average cost of capital. This is the cost of capital which is formulated by giving weights to who is type of capital and multiplying with their respective costs.

WACC= ( Weight of common stock* cost of common stock.)+(weight of preferred stock* cost of preferred stock + ( weight of debt* cost of debt).

Thus ROCE/WACC will result in in effective return on capital employed per unit of effective weighted average cost of capital.

Suppose ROCE =12%

And WACC= 10%

Then , ROCE/ WACC= 12%/10%=1.2

Thus , it is clear that this ratio shows the performance measure per unit of weighted cost of capital.

If this ratio is less than 1 then entity is not even able to recover it cost.

If this ratio is equals to 1 it means return and cost are equal.

This can only be beneficial if this ratio results results in in amount greater than 1.

# It can be a good performance measure as it clearly is clearly compares the return on capital employed with its associated cost by giving duly weightage to each of them.

Any project can be accepted only if the result of this ratio is greater than 1. Where this ratio is equal to 1 we are on Indifference point. i.e. whether to accept o r reject does not make any difference.

Thus this can be a good measure.

#Yes, it can be called return per cost on capital employed.

Or, benefit cost ratio.

Where benefit is ROCE and cost is WACC.

The student come up with this ratio and see call up it profit ratio. This is not the profit ratio. Profit ratio means profit margin. i.e. net profit divided by net sales.

It is measure of profitability as a percentage of sale, not as a a cost.