Return on Capital Employed (ROCE)
- Adam Edwards
- Nov 12, 2024
- 2 min read
Return on Capital Employed (ROCE) is a financial ratio that measures a company's profitability and efficiency in using its capital. ROCE is particularly useful in assessing how well a company generates profits from its total capital base, which includes both equity and debt.
Formula
The formula for ROCE is: Earnings Before Interest and Tax (EBIT) / Capital Employed
Earnings Before Interest and Tax (EBIT): This is the company's operating profit, which excludes interest and tax expenses. EBIT is used instead of net income because ROCE focuses on operational efficiency rather than the impact of financing and tax strategies.
Capital Employed: This represents the total amount of capital in use by the company. It is typically calculated as: Total Assets−Current Liabilities.
Alternatively, it can be calculated as:Shareholders’ Equity + Non-Current Liabilities (Long-Term Debt)
Interpretation of ROCE
Higher ROCE: A higher ROCE indicates that the company is generating more earnings from each pound of capital employed. For example, if a company has a ROCE of 15%, it means it generates £0.15 in profit for every £1 of capital invested.
Lower ROCE: A lower ROCE could suggest that the company is not efficiently using its capital to generate profits. However, ROCE should be compared within the same industry, as what is considered "good" varies widely by sector.
Example
Suppose a company has EBIT of £300,000 and capital employed of £2,000,000. The ROCE would be calculated as: 300,000 / 2,000,000 = 0.15 or 15%
This means that the company generates a 15% return on each pound of capital employed, which can be considered efficient if it’s above industry standards.
Why ROCE is Important
Measures Operational Efficiency: ROCE shows how efficiently a company generates profits from its capital base, focusing on operational returns rather than financing.
Indicator of Management Performance: A high ROCE suggests that management is effectively using both equity and debt to generate profits.
Useful for Comparing Across Industries: Unlike some ratios, ROCE is often used to compare companies across industries, especially in capital-intensive sectors, as it considers both equity and debt financing.
Limitations of ROCE
Ignores Current Liabilities: Since ROCE subtracts only current liabilities from assets, it might not reflect the full debt impact, especially if the company has high levels of short-term debt.
Impact of Depreciation and Asset Age: Older companies with fully depreciated assets may have artificially high ROCE because their capital employed is lower, making it look more efficient than newer companies.
Best for Long-Term Analysis: ROCE is most useful for evaluating long-term capital efficiency rather than short-term financial performance, as it includes both equity and long-term debt.
ROCE vs. Other Ratios
ROCE differs from Return on Equity (ROE) in that it considers both equity and debt, providing a broader view of a company’s capital efficiency.
It also differs from Return on Assets (ROA), which focuses solely on the profitability relative to total assets and doesn’t account for capital structure.