Structure of the ROCE tree
This type of analysis is called a ROCE Tree as it is often represented in the shape of a tree:
A few comments about the calculations of the tree:
Analysis of the information obtained based on a case study
You can download below an example of a ROCE tree. This example has been used by an investment banker to analyze the value of a potential investment.
Download here the case study from AccessCAPITAL
http://www.competia.com/downloads/Exercise-ROCE.pdf
This is how you would analyze the ROCE Tree:
Step 1: ROCE: Always starting from the left, you will compare the ROCE from one year to the other.
In our example, this ROCE has more than doubled from 3.29% to 7%. This is a large increase. This means that for each dollar invested in the company, shareholders have been able to get more than twice the return a rare thing these days!
Step 2: Capital turnover: You will then try to understand if this difference is coming from the way the company is generating a profit from the capital (the turnover of capital employed), or from the way it is generating return from the revenue (the operating profit). In our example: clearly, the difference is all coming from the profit generated from the revenue. The capital turnover has not changed from year 2 to year 1, and the operating margin has more than doubled.
Step 3: Return: You will then continue to slide to the right and try to understand where this doubling of return is coming from:
Step 4: Making your way across the top of the tree, confirm that the capital turnover has not changed. In this case, even if the turnover has not changed, the components of this ratio have changed:
In conclusion, the summary of this company’s financial statements could sound as follows:
“This is a company which has drastically increased the Return on the Capital Employed. This is mostly due to a large improvement of its operating margin. This is due to three main factors: first, a reduction of Cost of Goods Sold due probably to a better negotiation with suppliers and/or an investment in new equipment and manufacturing capabilities. Secondly, a reduction in sales and administrative costs. In parallel, the company has reduced its working capital requirements, probably by reducing accounts receivable, increasing its payment terms with suppliers and reducing its inventory.”
Tips to make this analysis successful
I wanted to leave you with a few tips to make this analysis successful:
http://www.competia.com/downloads/ROCE_template_cpfeb2004.xls
Want to know more?
The following books are available at Amazon.com: (We are a registered Amazon associate, and the reference fee we receive is reinvested in Competia to help make it a better product.)
The Analysis and Use of Financial Statements by Gerald I. White World / Canada
Analysis of Financial Statements by Leopold A. Bernstein, John J. Wild World
Techniques of Financial Analysis: A Modern Approach by Erich A. Helfert World / Canada
Conclusion
In order to remain competitive with a product that has reached its maturation point in its life cycle, a quick solution is to slash prices or implement a flashy promotion campaign to convince consumers to select their product over the competition. The pitfall of utilizing such marketing strategies is that they are short-term solutions for a long-term problem. Market segmentation analysis at the maturity stage permits companies to revisit and re-assess their current target market and examine their needs and wants which might have changed in over a period of time. Taking the changes into account, product managers can adapt their product with the intention of introducing it to new segments that will be discovered by the managers over the long term.
Estelle Mtayer * is president of
Competia . Competia is North America’s
leading consultancy and training organization for senior executives
and analysts in Strategic Planning and Competitive Intelligence. Its
flagship product, Competia.com, is the world’s largest community,
portal and magazine for strategy professionals. Competia.com enables
thousands of registered users to access each month a wealth of
resources: news on the advancement of their profession, practical and
hands-on tools and analysis techniques especially designed to help
them increase efficiency in their work. A former consultant at the
international strategic consulting firm McKinsey & Company, Estelle
has written and lectured widely on the process involved in turning the
intelligence gained into actions.
Estelle can be reached at estelle@competia.com
