Return On Capital Employed

The oil companies are eligible for return on total capital employed (TCE) consisting of average net fixed assets (NFA) and normative working capital (NWC).

NFA is the Gross block of fixed assets as reduced by accumulated depreciation as on a balance sheet date. Capital work-in-progress will not form apart of Gross block (and thus not form part of NFA) and hence will not be considered as a part of TCE. Similarly any portion of NFA related to manufacture of products other than those considered under APM shall be excluded. Average NFA shall be a simple arithmetical average of NFA outstanding as at the beginning of the pricing period and end of the pricing period.

NWC, in the case of refining companies, is computed by taking 45 days of imported crude throughput and 35 days of indigenous crude throughput. In case the refinery processes both indigenous and imported crude, weighted average of 35 days of
indigenous/ 45 days of imported crude throughput is taken as NWC. To compute the amount of NWC, crude is valued at Pooled FOB Price of Rs1700/ mt. In case the crude oil stock holding alone is in excess of 21 days throughput, additional compensation is allowed for stocks held in excess of 21 days valued at actual crude cost. In the case of marketing companies, NWC is computed by taking 30 days cost of sale (including inter-company sales) and the products are valued at ex-refinery prices plus applicable excise duties.

Thus TCE = NFA + NWC

The TCE so computed is compared with the Average networth (ANW) for the relevant period. In the case of integrated oil companies, ANW is allocated over refining, marketing and pipeline activities based on the capital employed in each of these activities. If the TCE is greater than ANW, then 12% post-tax return is given on ANW and the balance ie (TCE-ANW) is treated as deemed borrowings on which the weighted average cost of borrowings is reimbursed. If TCE is less than ANW, then 12% post-tax return is given on TCE only and thus no return is earned on the balance portion of ANW. To the aggregate return so computed, a bonus at 8.33% of annual wages is added. A simple illustration as to how the return is calculated is given in table.

Illustration for return on capital employed

Balance Sheet As At (Rs mn)

Average NFA 13,000 (12,000+14,000)/2

NWC 1,095

TCE 14,095

Consisting of

Average Networth 11,750 (11,000+12,500)/2

Deemed borrowings 2,345 (TCE - Avg NW)

Gross Margin

on Average NW 2,169 (12%/(1-35%) x Avg NW)

on Deemed borrowings 352 (15% x Deemed borrowings)

Bonus @ 8.33% 75 (assumed wages - Rs900mn)

Total 2,596

Return per mt of Crude 433 (2596/6.0)

Average WC (assumed to be simple average) 1,650 (1800+1500)/2

NWC 1,095

Diff WC on which returns (lost)/gained (555)

Actual Interest Costs 1,020 (15% of avg borrowings)

Interest costs reimbursed 352

The aggregate return to be earned on capital employed would also depend crucially on the composition of networth and deemed borrowings.

The results more than adequately explain as to why the ROCE of BPCL, for example, is higher than that of HPCL and IOC. The TCE for both HPCL and IOC is higher than the networth (without excluding the assets / networth related to free trade products) as shown in table. Since the networth is being diverted for investments/ CWIP not covered under APM, and the post-tax yield on these investments does not presumably exceed 12%, ROCE is lower.

As in the case of operating costs, the aggregate return is worked out per unit of standard throughput/ sales volume as per Sales Plan Entitlement. The actual earnings would be a multiple of the actual throughput/ sales volumes and the standard return per unit. The earnings would therefore depend upon the actual performance in a period.

It may also be noted that there is no scientific basis for arriving at the NWC. In practice, there are other components of working capital, which#include stores & spares, catalysts & consumables, book debts etc that are not considered for the purpose of compensation. Thus a significant difference between the actual working capital and NWC is likely. The companies would save if the actual working capital is lower than the NWC and contrarily stand to lose if actual working capital is more than the NWC. Given the large sale volumes, these variations can significantly affect the Profit & Loss account of the companies.

Yet another point to be noted is that variation in tax rates could have significant impact on the bottom-line of oil companies. With the fall in tax rates, the gross margin drops, as gross margin on networth is calculated by dividing the pre-tax return of 12% by a factor equal to (1-Tax rate) [for eg for a tax rate of 50% the factor would be 2]. As the rate of gross margin is not linked to actual tax outflows, with every fall in the tax rate, the factor increases and the rate of gross margin decreases. The workings have been made for three hypothetical companies with an equal capital employed of Rs27,500mn, but with varying combinations of networth and deemed borrowings and with varying amounts of tax depreciation.

The following results emerge

• If the networth is higher, the decrease in margins at the gross level is higher but the decrease at the net level is lower.
• The earnings at the net level decreases with increases in tax depreciation and vice-versa.
• No impacts on earnings if the book depreciation and tax depreciation is equal.

It may however be noted that the margins of the oil companies are in the form of claims from OCC and these claims are accounted in the books of the companies only after in-principle acceptance of these claims by OCC. This invariably results in postponement of earnings to subsequent years. For eg about 30% of the margins pertaining to the period 1993-96 was released by OCC in the financial year
1996-97 and these claims have been accounted by the oil companies in 1996-97. Whereas the tax rate in 1996-97 is 43%, the tax rate in 1993-94, 1994-95 and 1995-96 was 51.75%, 46% and 46% respectively. The gross return on networth would be based on the tax rates of the respective years whereas the actual tax outflow would be based on the tax rate of the year in which the margin is recognized. This has a significant bearing on net earnings of the oil companies. To take the above example, whereas the actual pre-tax return on networth in the three years, at a tax rate of 43% would be 24.87%, 22.22% and 22.22% respectively. The post-tax return on networth would be 14.18%, 12.67% and 12.67% respectively. By postponement of earnings, the post-tax return has thus increased beyond the normative return of 12%. Where tax rates are falling, postponement of accruals result in increases in net return and where tax rates are rising, postponement results in a decrease in net return.

With the tax rate sharply dropping to 35% in 1997-98, there could be a sharp variation in net earnings in respect of margins of previous year accounted in 1997-98.