Return on capital employed, or ROCE, is a financial ratio that’s used to measure how efficiently a company uses its capital to generate profits.
ROCE is calculated by comparing a company’s net operating profit to the total amount of capital used. This allows investors to see how much profit a company can generate from each pound or dollar of capital employed to run the business.
Because ROCE is a ratio, it’s a useful metric for comparing profitability across several different companies. By comparing the ROCE of different companies, investors can see which company uses its capital most efficiently to generate profits.
Like many other financial metrics, return on capital employed has its own range of advantages and disadvantages. Below, we’ve explained how return on capital employed works and why it’s an important metric for investors, as well as its strengths and limitations.
What is Return on Capital Employed?
Return on capital employed is a financial profitability ratio. It uses a simple formula to show how efficiently a company uses its capital to generate profits. The formula for calculating ROCE is as follows:
ROCE = Net Operating Profit (or Earnings Before Interest and Tax) / Capital Employed
In this formula, net operating income (or earnings before interest and tax), is the total amount of profit generated by the company, excluding taxes and interest.
Capital employed is the equity invested in the business, or the sum of the shareholders’ equity in the company. You can also calculate capital employed as the total value of the assets of the company, minus the company’s current liabilities.
Why is Return on Capital Employed Important?
Return on capital employed is an important ratio because it allows investors to compare several companies. If you’re an investor, you can use ROCE to see which company out of several uses its capital most efficiently to generate profits.
ROCE is highly useful for comparing capital intensive-businesses (businesses that operate in industries that require massive amounts of capital expenditure). Examples of capital-intensive businesses include car manufacturers, steel producers, airlines and railways.
Because these businesses have huge expenditures, efficient use of capital is a major strength that can make a company a preferred opportunity for investors.
For example, a company with a return on capital employed of exactly 1 earns a pound of profit for every pound invested in capital employed. A competing company in the same industry with a return on capital employed of .5 makes half as much for every pound of capital employed.
It’s important to know that return on capital employed often favours small companies without a large amount of assets. For example, a company with large operating profits but little assets is likely to have a higher ROCE than a company with similar profits and more valuable assets.
Return on Capital Employed Example
Here’s an example of return on capital employed in action. Imagine you’re considering investing in a company that sells ice cream. The company has an annual operating profit of £200,000, as well as assets of £200,000 and current liabilities of £50,000, according to its balance sheet.
With a total of £200,000 worth of assets and £50,000 in liabilities, the ice cream company’s total capital employed is £150,000. To calculate the return on capital employed for this business, we need to use the following formula:
£200,000 (Net Operating Profit) / £150,000 (Capital Employed) = 1.33
Using this calculation, we can see that the ice cream business has an ROCE of 1.33, meaning that £1.33 is earned for every £1 employed by the business.
Now, imagine you received a proposal to invest in a competing ice cream company at the same time as the first one. This ice cream company is a little bigger, with an annual operating profit of £350,000, assets worth £400,000 and current liabilities of £80,000.
Again, we can calculate the second ice cream company’s return on capital employed using the following formula:
£350,000 (Net Operating Profit) / £320,000 (Capital Employed) = 1.09
Using this calculation, we can see that the second ice cream company generates less money per pound invested in the company. Instead of £1.33 for every £1 employed, this business is only generating £1.09 for every £1 in capital employed.
While other factors might make one business or the other a better investment, it’s clear that the first ice cream business has a higher return on capital employed.
Strengths and Limitations of Capital Employed
In general, a higher ROCE is a good sign that a company is worth considering for investment, as it shows the company can efficiently turn capital into operating profits. However, like almost every other financial ratio, ROCE has several limitations:
While ROCE is fantastic for comparing similar companies within the same industry, it doesn’t provide many accurate insights when used to compare companies in different industries.
Relying solely on ROCE to compare companies could potentially cause you to ignore other factors that make one company or another an appealing investment. Because of this, it’s best to also use other ratios when you’re comparing investment opportunities.
Like other financial ratios, ROCE can fluctuate from year to year as each company deals with market conditions. This makes it important to look at ROCE trends over the course of several years when you’re comparing different companies.
Companies with large unused cash reserves will usually show an artificially low ROCE, as the cash reserves will affect the ratio. These cash reserves can have benefits of their own that aren’t expressed in an ROCE ratio.
By learning how to calculate return on capital employed, you’ll find it easy to identify companies that use their capital efficiently. This can be very helpful when you’re considering investing in a certain industry and want to compare companies to identify top performers.
Like other financial ratios, ROCE works best when it’s used as one of several tools to assess a company’s performance. Use ROCE with other ratios such as return on equity (ROE) and you’ll gain a powerful analysis tool to help you dig into a company’s performance.
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