Return On Capital Employed (ROCE) is a ratio that seeks to measure the return generated by the investments of a company.
Seen in another way, it is a way to measure the efficiency of the company when investing its capital to produce profits. This will depend, among other factors, on the decisions of the managers.
There is no ideal result for ROCE. It will depend on the sector to which the firm belongs. For example, a call centre service business employs less capital than a metalworking company.
In any case, ROCE can be particularly useful for sectors intensive in the use of capital, such as utilities (public services) or telecommunications (a sector that requires a large investment in fixed capital).
How to calculate ROCE?
ROCE is calculated with the following formula:
ROCE = EBIT / Capital Employed
Also, ROCE = Operating Result / (Net Financial Debt + Net Equity)
EBIT = Earnings before interest and tax
Capital Employed = Total net equity + Net Financial debt (excluding current liability) OR
Capital Employed = Total Assets – Current Liability
Also, the EBIT is an operating result, that is, it does not take into account income or financial expenses (interest), nor the Corporate Tax (or its equivalent in the country).
The capital employed takes into account the resources provided by the shareholders and the creditors. Therefore, we are interested in knowing what is the profit achieved before paying interest, that profit is the operating result (EBIT).
How to interpret ROCE?
The return on capital employed result shows how much operating income is generated from each penny the investors and creditors contribute. The profitability of the contribution is the ration that indicates how well the company is doing and potential growth.
Generally, the higher the ROCE, the more favourable as it indicates more income and potential higher dividend to investors.
For example, a ROCE of 10% means that for every 100 euros contributed by creditors and shareholders, the company generates 10 euros, which will be used to pay the shareholders and creditors themselves. Thus, as this ratio takes higher values, the company is more efficient in the use of the contributed resources.
Like other ratios such as ROE and ROA, this indicator should be compared with those obtained by companies in the same sector. That is, when comparing companies in the same industry, the one with the highest result will be preferred, as it means that the business offers a higher profitability.
Similarly, a time analysis can be done, and those companies with a stable and/or growing ROCE will be preferred, instead of those with a very volatile ROCE or that is falling.
Advantages and Disadvantages of ROCE
Among the advantages of ROCE we can find:
- It allows comparing profitability between companies in the same sector.
- Unlike other profitability ratio, such as ROE, it provides a comprehensive overall performance by considering both profitability and capital efficiency. That is, it doesn't only take into account the contribution of shareholders, but also resources from third parties such as creditors.
- It is relatively easy to calculate based on the data we can get from the financial statements.
- It's a useful management tool for assessing the performance of different business units or projects within the company
However, ROCE can also have disadvantages, they include:
- A low ROCE may be due to the company keeping a lot of cash in its balance, which is included in the employed capital (because it is part of the asset). Therefore, high cash levels can yield a biased result of the indicator.
- It is incomparable across sectors due to differences in capital intensity and business structure.
- It is an indicator that is based on financial statements, which are “the snapshot of the moment”. Therefore, it may not provide an accurate result based on the future earnings expected from the business.
- It does not take into consideration different associated risks, for example, to external variables that can affect the company.
- ROCE is susceptible to manipulation through financial engineering and accounting techniques.
Example of ROCE
Suppose we have the following data from two companies:
- Total assets: 15,000
- Current liability: 8,000
- EBIT: 1,350
- Net equity: 3,000
- Liability: 5,000
- Current liabilities: 2,500
- EBITDA: 1,250
- Depreciation and amortization: 160
Employed capital: Total assets – current liabilities= 15,000 – 8,000 = 7,000
ROCE: EBIT/Employed capital = 1,350/7,000 = 0.1929
Employed capital = Equity + Net financial debt (Liabilities – current liabilities)
Employed capital= 3,000 + (5,000-2,500)=3,000 + 2,500 = 5,500
EBIT: EBITDA – Depreciation and amortization =1,250 – 160 = 1,090
ROCE = 1,090 / 5,500=0.1982
It can therefore be concluded that, if both firms are from the same sector and we can compare them, RG company offers a higher return on employed capital, despite having fewer assets. These can be calculated by adding the net equity plus the liabilities (3,000 + 5,000 = 8,000 and 8,000 > 15,000).
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FAQs about ROCE
What does it mean for a Capital to be employed?
It is the amount of capital used to conduct day-to-day operations, invest in new opportunities, and grow for the acquisition of profits. It also refer to the value of assets used by a company to generate earnings
What is a good ROCE for a company?
Generally, there is no industry standard for the least ROCE a company in any sector must generate. A good ROCE depends in the company's growth ride and choice of investors.
However, a high ROCE suggests a more efficient company in terms if capital employment.
How do I calculate Return on Capital Employed?
ROCE is calculated by dividing earning before interest and taxes (EBIT) by capital employed. It can also be calculated by dividing EBIT by the difference between total assets and current liabiulities.