Classification of organizations

Knowing the definitions and characteristics of organizations isn’t enough. You also need to understand the main types of organizations and what makes them different.

Definitions

Public organization

An organization owned or controlled by the government.

Private sector organization

An organization owned and controlled by the private sector (anything other than government).

Profit-seeking organizations

Profit-seeking organizations exist to make a profit. If they can’t do that over time, they may have to close.

Examples of profit-seeking organizations:

• accounting firms
• grocery stores
• car manufacturing companies.

The measurement basis: controlled performance is judged by how well the organization increases shareholders’ wealth through dividends, share price growth, and profits.

Not-for-profit organizations

Not-for-profit organizations are set up for reasons other than making profits. This category includes many different types of organizations, and some are so different from each other that it’s hard to measure and compare their performance.

Examples of not-for-profit organizations:

• government departments/divisions
• public hospitals
• charity groups

Because these organizations are so varied, it’s difficult to set “collective goals” across the whole group. Many don’t make sales or generate revenue in the same way profit-seeking organizations do. Even so, they often share one common objective: reducing costs.

Examples of public sector organizations:

• public schools
• public hospitals
• police
• military
• government departments

Examples of private sector organizations:

• businesses
• corporations
• small firms
• charities
• non-profit organizations

Sidenote

A key question comes up again:

How do organizations maximize shareholders’ wealth?

They aim to increase the following:

• Earnings/profit
• Dividends growth
• Share price growth
• Innovation

If the organization ensures that every investment it makes leads to one or more of these types of growth, it will maximize shareholders’ wealth.

In later studies, you’ll explore these ideas in detail. For now, we’ll look at them in a general way and focus on some ways growth can be measured.

Short-term measures

ROCE — Return on Capital Employed

Definitions

ROCE

One of the most important short-term measures. It shows the return earned on invested funds, expressed as a percentage.

$$\text{ROCE}=\frac{\text{Operating profit}}{\text{Capital employed}}\times 100\%$$

Here, capital employed includes both debt and equity. Operating profit is taken from the statement of profit or loss before interest and tax.

ROCE matters because it links profit to the capital invested. A higher ROCE generally indicates a stronger increase in shareholders’ wealth. A low (or negative) ROCE suggests the board of directors isn’t generating wealth effectively from the capital invested.

Example 1:

KTA is an investment agent and last year its operating profit was $\$100,000$, and its share capital was $\$2,000,000$. What was their ROCE at the end of the year?

$$\begin{array}{rl}\text{ROCE}& =\frac{\$100,000}{\$2,000,000}\times 100\\ & =5\%\end{array}$$

This means that every dollar invested by the company generated a $5c$ return. That might seem low, but context matters. For example, in 2020 during the COVID-19 pandemic, many companies incurred losses or shut down. In that environment, even breaking even could be seen as strong performance.

Steps taken:

• Identify operating profit
• Identify capital employed
• Apply the ROCE formula and convert to a percentage

Example 2:

KTA has made a profit after interest and tax of $\$70,000$ and had $500,000$ shares worth $50c$ each. The tax charge was $30\%$ for the period, and the interest expense was $\$10,000$. How much was the ROCE for the year?

This question requires you to work backwards to find operating profit.

If net profit is $\$70,000$ after interest and tax, we need to add back tax and interest to reach operating profit. To keep the structure clear, here’s the bottom section of a statement of profit or loss:

Line item	Amount
Operating Profit	—
Interest	—
Profit before tax	—
Tax	—
Profit after tax	—

Now, back to the question. We’re given profit after tax and interest.

To find profit before tax: profit before tax multiplied by $0.7$ (i.e., $1-0.3$, since the tax rate is $30\%$) $=\$70,000$

$$\begin{array}{rl}0.7x& =\$70,000\\ x& =\frac{\$70,000}{0.7}\\ & =\$100,000\end{array}$$

So profit before tax was $\$100,000$. Now add interest of $\$10,000$ to get operating profit:

$$\text{Operating profit}=\$100,000+\$10,000=\$110,000$$

Next, calculate capital employed from the share information:

• Shares in issue: $500,000$
• Value per share: $50c=\$0.5$

$$\text{Capital employed}=500,000\times \$0.5=\$250,000$$

$$\begin{array}{rl}\text{ROCE}& =\frac{\$110,000}{\$250,000}\times 100\\ & =44\%\end{array}$$

Steps taken:

• Start with profit after tax
• Convert to profit before tax
• Add back interest to find operating profit
• Calculate capital employed
• Apply the ROCE formula

Earnings per share

Definitions

Earnings per share

The earnings available to ordinary shareholders after all deductions, except dividend payments to ordinary shareholders.

$$\text{EPS}=\frac{\text{Profit after interest, tax, and preference share dividends}}{\text{Number of shares}}$$

ROCE uses capital employed (equity and debt), so the return is for all providers of finance. However, the primary owners of an organization are equity shareholders, so we also use earnings per share.

Example:

KTA had profit before tax of $\$250,000$, profit after tax of $\$200,000$, and it paid preference share dividends of $\$50,000$. The share capital of the company was $\$1,000,000$ with a nominal value of $\$0.5$ per share. What were the earnings per share for the year?

First, find earnings after interest, tax, and preference share dividends:

$$\$200,000-\$50,000=\$150,000$$

Next, find the number of shares. Since the number of shares isn’t given, divide share capital by nominal value per share:

$$\frac{\$1,000,000}{\$0.5}=2,000,000\text{ shares}$$

$$\begin{array}{rl}\text{EPS}& =\frac{150,000}{2,000,000}\\ & =0.075\end{array}$$

$$=7.5c$$

Steps taken:

• Subtract preference dividends from profit after tax
• Calculate the number of shares
• Apply the EPS formula

Example:

KTA had earnings per share of $\$0.1$ and had $1,000,000$ shares in issue. How much was the profit after interest, tax, and preference share dividends?

$$\text{EPS}=\frac{\text{Profit}}{\text{Number of shares}}$$

$$\begin{array}{rl}0.1& =\frac{\text{Profit}}{1,000,000}\\ \text{Profit}& =0.1\times 1,000,000\\ & =100,000\end{array}$$

You’ll want to be comfortable with both:

• identifying the correct components of each formula, and
• rearranging the formula to solve for a missing value.

Steps taken:

• Write the formula for earnings per share
• Substitute the known values
• Rearrange to solve for profit
• Multiply to find the total profit

Example:

Which of the following are true in terms of ROCE and earnings per share? Select all that apply.

A. Earnings per share are calculated after adding the operating profit to the profit after tax.
B. Both ROCE and earnings per share measure the growth of shareholders’ wealth.
C. Earnings per share are based on the overall earnings made by the company over the years divided by the number of shares.
D. Earnings per share are based on the current profit after tax and preference share dividends divided by the number of shares.
E. ROCE is a percentage return for all investors.
F. Both ROCE and earnings per share are short-term measures of shareholders’ wealth.

Solution: