Return on capital employed (ROCE) is a profitability metric that indicates a company’s efficiency in earning profits from its capital employed with respect to its net operating profit. Hence, ROCE tells investors how much profit they are generating for every dollar of capital employed.
The ROCE is a profitability ratio that reflects long-term prospects for a company as it shows asset performance while taking long-term financing into account. This makes the ratio more useful than the return on equity ratio when it comes to assessing the long-term performance and overall longevity of a business.
This number is hinged on two crucial calculations: net operating profit and, of course, capital employed. Net operating profit is also known as EBIT or earnings before interest and taxes. This is usually reported on the income statement since it shows the profits that a company has earned from its operations. In the calculation, interest and taxes can be added back into net iIncome if necessary. Capital employed can be a very complicated term as it is used in many other financial ratios. In most cases, it is related to a company’s total assets minus all current liabilities. It could also be viewed as stockholders’ equity after deducting long-term liabilities.
Return on Capital Employed Formula
$$ROCE = \dfrac{EBIT}{Capital\: Employed}$$
EBIT is the earnings before interest and taxes but you can also use the net operating profit instead.
Capital employed is the total amount of equity that has been put into the company. Capital employed may be calculated in two ways – total assets minus current liabilities, or fixed assets plus required working capital:
$$Capital\: Employed = Total\: Assets - Current\: Liabilities$$
The ROCE ratio reflects the amount of profit that every dollar of employed capital earns. Clearly, the higher the ratio is more favorable for the company. This is because it shows that more profits are being made per dollar from the money used to operate the business. For example, a return of 0.2 means each dollar of capital employed earned 20%, or 20 cents, of that dollar in profits.
Investors are concerned about the ratio because they want to know how efficiently the company is utilizing its capital employed. Also, they’re looking at effective its long-term financing strategies are. Companies should always earn more than the rate they pay in debt to finance the assets. If a business borrows money at 20% and it gets a return of only 5%, that means the company is losing money.
As with the Return on Assets ratio, the assets of a company can either help or prevent the business from earning a high return. A company with less assets but more profits will have a higher return compared to one that has more assets yet makes the same profits.
Return on Capital Employed Example
Innov is an interior design company that earned an EBIT of $150,000 over the year. Its balance sheet shows reported total assets worth $150,000 and current liabilities of $37,500 for the same year. What is Innov’s ROCE?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- EBIT: 150,000
- Capital Employed: 112,500
We can apply the values to our variables and calculate the return on capital employed:
$$ROCE = \dfrac{150{,}000}{112{,}500} = 133.33\%$$
In this case, Innov would have a return on capital employed of 1.33 or 133.33%.
A ROCE of 1.33 or 133.33% indicates that Innov is earning $1.33 for – or 133.33% of – each dollar of employed capital. This return may be too high, considering the company doesn’t have too much assets. When a business has big cash reserves, the ratio is probably skewed since cash is used in the calculation even if it hasn’t been actually used.
Return on Capital Employed Analysis
Although the ROCE is a good metric for profitability, it may not always accurately capture the performance of a company with huge cash reserves probably obtained from a new equity issue. Cash reserves are deemed part of capital employed, whether or not they have actually been employed. Hence, such cash reserves inclusion can lead to inflated capital and reduced ROCE calculations.
For example, a firm that has made a $15 profit on $100 worth of capital employed would have a ROCE of 15%. Of the capital employed, let’s assume that $40 was recently raised money that has not yet been used for operations. Disregarding this dormant cash, the capital would be about $60, boosting the ROCE to a 25%.
Moreover, there are instances where the ROCE may understate capital employed. In conservatism, intangible assets (trademarks, R&D, etc.) are not considered capital employed. Because it is extremely difficult to accurately determine the value of intangible assets, they end up excluded. This happens even if they are technically part of capital employed.
There are many other reasons investors may avoid the ROCE when trying to make investment decisions. For instance, the values used in ROCE calculations are coming from the balance sheet, which contains historical or past data. That means the resulting ROCE cannot give a correct, forward-looking impression. In general, the method is generally focused on short-term events. Therefore, it isn’t a good measure of a company’s longer-term achievements. Lastly, the ROCE cannot be made to explain various risk factors involved in a company’s various investments.
Return on Capital Employed Conclusion
- The return on capital employed ratio measures how efficiently a company is using its employed capital to earn revenues.
- This formula requires two variables: EBIT (earnings before interest and taxes) and capital employed.
- The return on capital employed is usually expressed as a percentage.
- Analysts favor this calculation because it shows more revenues are generated per dollar of capital employed.
- The return on capital employed ratio has a few limitations, such as its inability to provide a forward-looking picture of a company, since it is based on historical data.
Return on Capital Employed Calculator
You can use the return on capital employed calculator below to quickly measure how efficiently your business is using capital employed to earn profit, by entering the required numbers.