Return on Capital Employed (ROCE) Ratio Formula

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Return on Capital Employed (ROCE) Ratio Formula

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Return on capital employed (ROCE) is a financial ratio used to ascertain a company’s profitability and capital efficiency. It is a popular accountancy ratio that is used in the fields of accountancy, valuation, and finance. ROCE serves to measure how efficiently a company uses capital to generate profits. Taking into account the amount of capital used serves as a useful measure for comparing a company’s relative profitability.

This metric is considered one of the best long-term profitability ratios. It is commonly used by financial managers, stakeholders and potential investors to determine whether a company is suitable to invest in or not.

How is ROCE calculated?

To calculate ROCE (Return on capital employed), EBIT (Earnings before Interest and Taxes) or net operating profit is divided by capital employed. Here, capital employed implies the difference between the total assets of the company and all current Return on Capital Employed.

Return on capital employed (ROCE) is a financial ratio used to ascertain a company’s profitability and capital efficiency. It is a popular accountancy ratio that is used in the fields of accountancy, valuation, and finance. Taking into account the amount of capital used serves as a useful measure for comparing companies’ relative profitability. ROCE serves to measure how efficiently a company uses capital to generate profits.

This metric is considered one of the best long-term profitability ratios. It is commonly used by financial managers, stakeholders and potential investors to determine whether a company is suitable to invest in or not.

How is ROCE computed?

To calculate ROCE (Return on capital employed), EBIT (Earnings before Interest and Taxes) or net operating profit is divided by capital employed. Here, capital employed implies the difference between the total assets of the company and all current liabilities.

Formula:

ROCE is expressed as a percentage (%). The formula for the computation of ROCE is as follows:

ROCE = EBIT/Capital employed where,

  • EBIT = Earnings Before Interest and Tax
  • Capital Employed = Total Assets – Total Current Liabilities

 

Breaking down the main components of the ROCE ratio, we have Capital Employed and EBIT.

Capital Employed

Capital employed is generally calculated as either total assets less current liabilities or fixed assets plus working capital. It ultimately represents the total shareholders’ equity invested in a business plus the long-term debts.

We have capital employed in the denominator instead of total assets (which is the case of Return on Assets). Essentially, it is the capital investment required for the regular functioning of a business.

In the ROCE ratio, the reported capital figures of the end of the period are used. Alternatively, if the average of the opening and closing capital for the period were to be used, we obtain the return on average capital employed (ROACE).

Earnings Before Interest and Tax  

EBIT, also known as operating income, indicates how much a company earns from its operations alone without interest on debt or taxes. In other words, it is the total of a company’s profit, including all expenses excluding interest and tax expenses. EBIT is calculated by subtracting the cost of goods sold and operating expenses from revenues.

Instead of using capital employed at an arbitrary point in time, some analysts and investors may choose to calculate ROCE based on the average capital employed, which takes the average of opening and closing capital employed for the time period under analysis.

Why to Use the ROCE Ratio?

Value creation is possible when a business can generate returns on capital above their WACC (weighted average cost of capital). ROCE helps figure out the value a business gains from its liabilities and assets.

For instance, a business owning a lot of land (asset) than another business with the same profit will have a smaller ROCE in comparison. ROCE indicates how much a business gains or losses from its assets and liabilities.

Example:

Consider two companies operating in the same industry: ABC Corp. and XYZ Corp. The table below illustrates a hypothetical ROCE analysis of both companies.

Value in millions ABC Corp. XYZ Corp.
Sales $15,195 $65,058
EBIT $3,837 $13,955
Total Assets $12,123 $120,406
Current Liabilities $3,305 $30,210
Capital Employed (TA – CL) $8,818 $90,196
Return on Capital Employed 0.4351

~43.51%

0.1547

~15.47%

Explanation:

Observing from the above table, XYZ Corp has a much larger business than ABC Corp., with higher revenue, EBIT, and total assets.

Using the ROCE metric, you can see that ABC Corp is generating more efficient profit from its capital than XYZ Corp. ABC Corps’ ROCE is 44 cents per capital dollar or 43.51% vs. 15 cents per capital dollar for XYZ Corp or 15.47%.

Thus, it becomes necessary to compare the ROCE of ABC against its peers and not across different industries to determine if it is favorable or not. In the example, for ABC Corp, the ROCE of 43.51% means that for every dollar invested in capital, the company generated 44 cents in operating income. Compared with XYZ’s ROCE, which is significantly lower at 15.47%, we see that ABC Corp is a more profitable and efficient business.

Interpretation of ROCE

The return on capital employed illustrates how much operating income is generated for every dollar of capital employed. Although there isn’t any industry set standard, a higher ROCE (greater profit for 1$ generated) is considered more favorable.

Usually, two companies seem similar on the surface with respect to their profit margins, but they would have significantly different approaches towards spending capital. In situations like this, traders can use ROCE as part of their fundamental analysis to establish whether the company is effectively employing capital. An increasing ROCE ratio in a majority of cases implies strengthening long-term profitability.

To make a more conclusive decision, other profitability ratios such as ROA (return on assets), (ROE) return on equity and return on invested capital should be used alongside ROCE to justify investment in a company or not.

Advantages of using ROCE:

  • Unlike other fundamentals such as ROE (return on equity), which only analyzes profitability relative to a company’s shareholders’ equity, ROCE, on the other hand, considers both debt and equity financing. This can help neutralize financial performance analysis for companies with significant debt and gauge the profitability and performance of a company better over a period of time.
  • ROCE can be particularly useful when comparing capital-intensive sector companies such as utilities and telecoms.
  • The ROCE trend over the years can also be an important performance indicator for a company.
  • Companies with stable and increasing ROCE levels tend to be favored by investors over companies with volatile or lower trending ROCE.

Limitations of ROCE:

  • The primary drawback of ROCE is that since assets are measured against the book value of assets in the business, the ROCE will increase as assets are depreciated even though cash flow has remained the same. The newer, possibly better businesses would have a lower ROCE than older businesses with more depreciated assets.
  • Since cash flow is affected by inflation and the book value of assets is not, revenues increase along with inflation while capital employed normally does not.
  • It is important to note that a higher value ROCE may also indicate a company with a lot of cash (since cash is part of total assets). Due to this result, high levels of cash can at times skew this metric.

Closing Thoughts

  • The ROCE is a long-term profitability metric that can help understand how well a company generates profits from its capital usage and explains the profit generated by each dollar (or other unit of currency) employed.
  • A greater return on capital employed is favorable because it indicates more efficient capital employment.
  • The return on capital employed should be used along with other profitability ratios such as ROE, ROA etc., when making an investment decision or evaluating a company.
  • This metric offers little value for comparing companies across industries and should only be compared for companies operating in the same industry.
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