What Is The Return on Capital Employed (ROCE)?
Return on capital employed (ROCE) is a financial measure, which is used for checking how effectively a company is making profits from the money it uses. In simpler terms, it shows how well the company is using its capital to generate earnings. ROCE is a useful tool for financial managers, stakeholders, and investors, as it helps them to evaluate a company’s profitability and efficiency before making investment decisions.
ROCE – Key Takeaways
- Return on Capital Employed (ROCE) is a ratio that shows how well a company is using all its capital to make a profit.
- It is useful to compare ROCE between companies in the same industry since ratios can vary widely between different industries.
- A higher ROCE usually means a company is more profitable and reliable.
- Companies often look at several key ratios to assess their performance, including Return on Equity, Return on Assets, Return on Invested Capital, and Return on Capital Employed.
Return On Capital Employed Formula
Now, after understanding what ROCE is. You must be wondering about how it is calculated and what is the right way to measure it. So, let us understand the Return on capital employed formula to see how it is measured and what parameters to keep in mind while measuring it.
| Return On Capital Employed Formula |
| ROCE= Capital Employed / EBIT
Where:Â
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ROCE (Return on Capital Employed) is a measure that is used to assess a company’s profitability and compare it with others, based on the capital it uses. To calculate ROCE, you need two key components: earnings before interest and tax (EBIT) and capital employed.
EBIT, also known as operating income, shows how much a company makes from its core business activities, without considering interest on debt or taxes. You can find EBIT by simply subtracting the cost of goods sold (COGS) and operating expenses from the company’s total revenue.
Capital employed on the other hand, is similar to invested capital. To find capital employed, you have to subtract the company’s current liabilities from its total assets. This will give you the sum of shareholder’s equity and long-term debts. Some investors and analysts prefer to use the average capital employed instead of just one point in time. This approach takes the average of the opening and closing capital employed during the period under review.
Why Return On Capital Employed Is Used?
Return on Capital Employed (ROCE) is especially helpful when comparing companies in sectors that require a lot of capital, like utilities and telecoms. Unlike Return on Equity (ROE), which only looks at profits in relation to shareholder’s equity, ROCE takes both debt and equity into account. This makes it easier to compare companies with different levels of debt.
ROCE shows how much profit a company makes for every $1 of capital it uses. The more profit per $1, the better the company is performing. A higher ROCE means the company is more profitable compared to others. The trend of a company’s ROCE over time is also important. Investors usually prefer companies with steady or increasing ROCE, as it indicates consistent performance. On the other hand, companies with fluctuating or declining ROCE might be seen as less reliable.
Advantages Of Return On Capital Employed
Companies track ROCE (Return on Capital Employed) for several important reasons. Some of the most common advantages of ROCE are written below for your reference:
- ROCE gives a clear picture of how well a company is performing by looking at both its profits and how efficiently it uses its capital.
- It helps to evaluate how wisely the company is using its capital and whether it is generating good returns. This makes ROCE useful for comparing companies across different industries, showing how well a company can turn its capital into profits.
- For investors, ROCE is a key metric because it shows how effectively a company is generating returns on their investments. A high ROCE over time signals that the company is providing good returns, which can boost investor confidence and attract more investment.
- ROCE offers a long-term view of a company’s profitability and efficiency by considering profits over time in relation to the capital employed.
Disadvantages Of Return On Capital Employed
Apart from these plenty of advantages, there are several disadvantages of ROCE that users should be aware of when analyzing it. Let us understand its disadvantages with the help of points written below:
- ROCE mainly focuses on profitability and how efficiently a company uses its capital. However, it does not consider other important aspects of financial performance, like revenue growth, profit margins, cash flow creation, and return on equity.
- Since ROCE relies on past financial data, it may not accurately reflect current market conditions or future growth opportunities. It shows how successful past investments were but may not predict future profitability or the impact of new investments.
- Like other financial metrics, ROCE can be manipulated through accounting tricks or financial engineering. It may also fail to consider changes in the industry, the economy, or other factors that could affect a company’s performance.
- Relying only on ROCE metrics can give a narrow view that may lead to an incomplete assessment of a company’s current situation and future potential.
How You Can Improve ROCE
Improving ROCE (Return on Capital Employed) requires a clear and simple strategy that focuses on increasing profits and using capital more efficiently. Companies can do this by making their operations more efficient, wisely allocating capital, and regularly monitoring their progress.
Operational efficiency means making processes smoother, cutting costs, and boosting productivity to increase profits. This can be done by using lean practices, automating tasks, and improving workflows. These methods will help to reduce waste and make operations more effective. Capital allocation involves choosing the right investments. Companies should focus on projects that offer the best returns and match their long-term goals. Managing working capital is also crucial, such as reducing the cost of holding inventory and speeding up the collection of payments, especially for profitable projects.
Asset optimization is about making the best use of a company’s assets to get the most returns. This might include renegotiating leases, selling off unused assets, or sharing resources to cut costs. ROCE improves when companies use less capital by avoiding unnecessary expenses and long-term investments. This means they get better returns with the resources they have. Additionally, companies should regularly review their pricing and profit margins. Growth strategies should aim to increase market share, develop new products, and build strong customer relationships.
Investing in employee training and managing risks are also important, as these can directly impact ROCE. Regular monitoring and evaluation are essential to track progress and find areas for improvement. Finally, companies need to alter their strategies to fit their industry, competition, and internal strengths to see lasting improvements in ROCE. It’s important to be aware that changes to improve ROCE might have other unintended effects, so careful planning is the key to success.
Return on Capital Employed (ROCE) vs. Return on Invested Capital (ROIC)
| Parameters | Return on Capital Employed (ROCE) | Return on Invested Capital (ROIC) |
| Definition | It measures the profitability by calculating earnings before interest and tax (EBIT) relative to total capital employed. | It measures profitability by calculating net operating profit after tax (NOPAT) relative to invested capital. |
| Formula | ROCE = EBIT / Capital Employed | ROIC = NOPAT / Invested Capital |
| Capital Considered | Total capital employed, including equity, debt, and other long-term liabilities. | Only invested capital, which basically includes equity and debt used directly in the business. |
| Use | Commonly used for comparing profitability across companies in capital-intensive industries. | Often used to assess the effectiveness of a company’s investment decisions. |
| Impact of Non-Operating Assets | Includes all capital employed, so non-operating assets may distort the ratio. | Excludes non-operating assets, providing a clearer view of operational efficiency. |
| Sensitivity | Can be less sensitive to changes in net income since it focuses on EBIT. | More sensitive to changes in net income due to the use of NOPAT. |
| Ideal For | Evaluating the overall capital efficiency of a company. | Assessing the returns generated from capital invested specifically for operational purposes. |
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Return On Capital Employed FAQs
Why is ROCE important?
ROCE is important because it shows how effectively a company uses its capital to generate profits. A higher ROCE indicates better efficiency and profitability, making the company more attractive to investors.
How is ROCE different from ROE (Return on Equity)?
ROCE considers both equity and debt in its calculation, making it a broader measure of profitability, whereas ROE only considers shareholder's equity.
What is a good ROCE?
Generally, a ROCE of 15% or higher is considered good. However, it is crucial to compare it with the industry average for a more accurate assessment.
How does debt impact ROCE?
Companies with high levels of debt might show a higher ROCE due to a smaller capital employed base, but this can be risky if the debt is not managed well.
