Return on Capital Employed: a common financial target
When analyzing financials of large Nordic companies I often see Return on Capital Employed (ROCE) included in their financial targets. Other targets are related to revenue growth, debt ratio and dividend. Various formulas are being used to calculate ROCE, but a common formula is: ROCE = EBIT / Capital Employed, in which Capital Employed = Total Assets -/- Current Liabilities (Investopedia). ROCE measures both the profitability and the efficiency of the capital used to generate the profit. But how can companies increase their ROCE figure and achieve their target? In short by increasing Returns and decreasing Capital Employed, but how to do this? And how can Supply Chain Finance (SCF) support?
One way to improve a company’s profitability is by capturing cash discounts on purchases, which suppliers can offer in exchange for early payment. Cash discounts come in all shapes and sizes, but a common cash discount is 1/10, net 30. This means the payment term is 30 days, but a buyer receives a 1% discount when the invoice is paid within 10 days. The annual percentage rate of this cash discount is 18%, which is higher than the average ROCE target and an argument for capturing the discount. However, the impact on a buyer’s profitability depends on whether or not these discounts are offered by the suppliers and captured by the buyer.
Another way to improve profitability is by negotiating price reductions. The success of these negotiations depends on a company’s purchasing power. Let’s say you are in a good negotiating position; how far can you go in negotiating price reductions without offering access to early payment such as Supply Chain Finance? How much pressure can your suppliers take before it backfires with supply chain disruptions?
… on Capital Employed
There are different ways to decrease the amount of capital employed. Within fixed assets, this is possible for example by selling unused office or production space or by selling obsolete machinery. Within current assets, this is possible for example by decreasing inventory levels or decreasing accounts receivable. The latter can be achieved by using accounts receivable financing, factoring or by offering cash discounts.
Another way to decrease the amount of capital employed is by increasing accounts payable. Accounts payable is part of current liabilities, which is deducted from the total assets in the capital employed formula (total assets -/- current liabilities). Increasing accounts payable can be achieved by extending supplier payment terms, for example from 30 to 45 days. But how much further can you go in negotiating payment term extensions? What if you want to extend supplier payment terms to 60 or 90 days? Depending on the suppliers’ cost of capital, this can put a high pressure on their margins.
What part does Supply Chain Finance play in this equation?
Supply Chain Finance is a financial arrangement focused on creating a win-win solution for both the buyer and its suppliers. Therefore, it acts as a catalyst in the payment term negotiations between these parties. Suppliers get access to early payments against favorable rates, which often is lower than their own cost of borrowing. The early payment can be funded either by the buyer (self-funding) in which case it is called Dynamic Discounting or by a financial institution (bank or investment fund) in which case it is called Reverse Factoring. The early payment towards suppliers enables the buyer to gain working capital and/or profitability improvement without putting pressure on suppliers’ margins.
Supply Chain Finance can have a substantial impact on a company’s ROCE figure. However, this depends on several factors, such as the buyer’s ambition for the program and success of the implementation. How far can you, as a buyer, go in negotiating payment term extensions or price reductions, so that it still results in a cost-positive situation for your suppliers? How many suppliers do you want to include in the program and how do you categorize and prioritize them? Is the implementation project run by a cross-functional team with C-level commitment and a sufficient amount of resource commitment?
Careful planning and finding the right answers to these questions is the key to reach your ROCE targets.
OpusCapita has the tools and expertise to successfully implement programs , maximize the results by onboarding also the long tail of suppliers, which amounts to a substantial impact on your company’s ROCE figure.
Jos Groen works as a Financial Analyst at OpusCapita. He has developed the SCF Readiness Quickscan and won the 3rd prize in the 2016 SCF Community Global Thesis Awards. In his current role he helps companies to improve their working capital efficiency and to maximize SCF program results.
>> Read the blog “Supply Chain Finance: Ready to get into the driver’s seat?”
>> Watch the webinar recording “How to release working capital and tackle payment term extension challenges with supply chain finance”