What Is Return on Capital Employed (ROCE)?

What Is Return on Capital Employed (ROCE)?

Let me explain return on capital employed, or ROCE, directly to you. It's a financial metric that reveals how effectively a company generates profits from the capital it uses. Think of it as a straightforward measure of profitability. You'll find it among various financial tools that analysts and investors use to assess a company's financial health.

Key Takeaways

ROCE is a ratio that gauges a company's profitability based on all its capital. You calculate it as earnings before interest and tax—also known as operating income—divided by capital employed. The higher this ratio, the more profits the company pulls from its capital. Remember, ROCE accounts for both debt and equity. I always recommend comparing ROCE only among companies in the same industry, as values differ across sectors.

Formula and Calculation of Return on Capital Employed (ROCE)

Here's the formula for ROCE: ROCE equals EBIT divided by capital employed, where EBIT is earnings before interest and tax, and capital employed is total assets minus current liabilities. This metric helps you analyze profitability and compare how companies utilize capital. To compute it, you need two main components: EBIT and capital employed. EBIT, or operating income, comes from subtracting cost of goods sold and operating expenses from revenues—it shows earnings from core operations without debt interest or taxes. Capital employed is straightforward: subtract current liabilities from total assets, giving you shareholders' equity plus long-term debts. Some prefer using average capital employed over a period, averaging opening and closing values, instead of a single point in time.

What Return on Capital Employed (ROCE) Can Tell You

ROCE is particularly helpful when you're comparing companies in capital-heavy industries like utilities or telecoms. Unlike return on equity, which focuses only on shareholders' equity, ROCE includes debt, making it a balanced view for debt-laden firms. Essentially, it shows you the profit generated per dollar of capital employed—the higher, the better for profitability comparisons. Tracking a company's ROCE trend over years is key; stable or rising ROCE is preferable to volatile or declining ones, as investors favor consistency.

Advantages and Disadvantages of ROCE

On the advantages side, ROCE gives you a full picture of a company's performance by blending profitability with capital efficiency. It aids in evaluating capital allocation and return generation. You can sometimes compare it across industries, highlighting profit-making ability from capital. For investors, a high ROCE signals strong returns, building confidence and attracting capital. Internally, it's a tool for managers to assess units or projects, spotting inefficient capital use and guiding resource decisions. It offers a long-term view, relating extended profitability to capital used.

Now, the disadvantages: ROCE isn't always comparable across sectors due to varying capital needs and structures. It focuses narrowly on profitability and efficiency, ignoring revenue growth, margins, cash flow, or return on equity. Being based on historical data, it doesn't capture current markets or future growth. Like any metric, it's open to manipulation through accounting tricks. It may overlook broader industry or economic changes affecting performance. Relying solely on ROCE can limit your overall assessment of a company's situation.

How Companies Can Improve ROCE

To boost ROCE, companies need a strategy emphasizing profitability and capital efficiency through operational streamlining, smart allocation, and ongoing evaluation. Start with operational efficiency: implement lean practices, automation, and process tweaks to cut costs and boost productivity. For capital allocation, prioritize high-return projects that fit strategic goals, and manage working capital by optimizing inventory, receivables, and payables. Asset optimization means maximizing returns from assets—renegotiate leases, sell underused ones, or share models. Remember, using less capital improves ROCE by avoiding unnecessary costs. Review pricing and margins, push revenue growth via market expansion and innovation, invest in employee skills, and manage risks. Always monitor progress and adapt to your industry and capabilities, but watch for unintended negative effects elsewhere.

ROCE and Business Cycles

ROCE ties closely to economic cycles. In expansionary phases, rising demand and sales can lift ROCE through higher revenues and efficient capital use. At the peak, slowing growth and competition might stabilize or slightly drop ROCE. During contractions, falling demand pressures profits, often lowering ROCE. In recovery, effective cost control can start rebuilding ROCE. Early growth phases see fluctuations as new investments may initially drag it down but can raise it if successful.

Return on Capital Employed (ROCE) vs. Return on Invested Capital (ROIC)

Both ROCE and ROIC measure profitability per capital, and ideally, they should exceed the weighted average cost of capital for long-term profitability. ROIC uses net operating profit after tax divided by invested capital, factoring in taxes unlike ROCE. Invested capital is more detailed, possibly including net working capital plus PP&E and intangibles, or total debt and equity minus non-operating cash.

Example of How to Use ROCE

Take two companies in the same industry: ACE Corp. with sales of $15,195 million, EBIT of $3,837 million, total assets $12,123 million, current liabilities $3,305 million, so capital employed $8,818 million and ROCE 0.4351 or 43.51%. Sam & Co. has sales $65,058 million, EBIT $13,955 million, total assets $120,406 million, current liabilities $30,210 million, capital employed $90,196 million, and ROCE 0.1547 or 15.47%. Despite being larger, Sam & Co. is less efficient in profit generation from capital.

What Does It Mean for Capital to Be Employed?

Companies employ capital for operations, investments, and growth. Capital employed is total assets minus current liabilities, useful with other metrics to gauge asset returns and management effectiveness.

Why Is ROCE Useful If There Are Already ROE and ROA Measures?

ROCE stands out over ROA and ROE because it includes both debt and equity, offering a broader profitability gauge over time.

How Is Return on Capital Employed Calculated?

Divide EBIT by capital employed, or equivalently, by total assets minus current liabilities.

What Is a Good ROCE Value?

No universal standard exists, but higher ROCE means better efficiency. A 20% or more is often positive, though high cash can skew it low. Compare within industries only.

The Bottom Line

Use ROCE to assess a company's profitability and capital efficiency from its financial statements. Stick to same-industry comparisons, and note that 20% or higher generally indicates strong performance.