If you focus on the name itself, it is a financial ratio that expresses your return on the capital employed by the company.
Capital employed by the company is the total of all the money invested in the company. This is why the ratio is known as the return on capital employed.
What is the Return on Capital Employed (ROCE)?
Return on capital employed is one of the most important profitability ratios that can be used to evaluate how efficiently the company uses its total capital and tells you the profit generated by each rupee employed.
In another word, the ROCE ratio is a financial ratio that can be used for analyzing the profitability and capital efficiency of a company.
ROCE ratio is one of the few profitability ratios that investors or analysts assess to understand a company's profitability before investing in a company.
Understanding ROCE
Return on capital employed is one of several profitability ratios that assist the investors to comprehend the financial profitability performance of a company and rate of returns to its investors with the use of Return on Assets and Return on Equity ratios.
It also demonstrates how efficiently a company can earn incomes from total capital in business operations.
ROCE ratio is the long term profitability ratio that shows how effectively a company's assets are performing for a long period of times. This is why the return on capital employed is better than the return on equity.
How to calculate Return on Capital Employed?
The return on capital employed has two major components and these are earnings before interest and tax (EBIT) and capital employed.
The ROCE formula is calculated by earnings before interest and tax dividing by Capital employed. The ROCE formula is given below:
Return on Capital Employed = (Earnings Before Interest and Tax / Capital Employed)
Earnings Before Interest and Tax (EBIT)
EBIT is also known as net operating income that indicates how much a company earns from its operations without taking interests or taxes. We can get at the EBIT company's income statement.
Earnings before interest and tax are calculated by subtracting the cost of goods sold and operating expenses from revenues.
EBIT = (Revenue – Cost of goods sold – Operating expenses)
Capital Employed
The capital employed shows the total amount of capital investment in a business and indicates how a company is investing its total capital, which comprises shareholders' equity and long term liabilities.
Some analysts or investors may Calculate Capital employed by deducting the current liabilities from the total assets.
However, the most simple method of calculating capital employed is by adding share capital to the company's debt capital.
Capital Employed = (Total assets / Current liabilities)
Return on Capital Employed Example
It is an ABC company. Here is some information about ABC company,
| Share captital | ₹ 70,000 |
| Reserve | ₹ 10,000 |
| Long-term liablities | ₹ 50,000 |
| Current liablities | ₹ 70,000 |
| Assets | ₹ 200,000 |
| EBIT | ₹ 50,000 |
| Interest | ₹ 10,000 |
| EBT | ₹ 40,000 |
| Tax (40%) | ₹ 16,000 |
| EAT | ₹ 24,000 |
Capital Employed = 70000 + 50000 + 70000
Capital Employed = 190000
ROCE = (50000 / 190000)
ROCE = 0.26 or 26%
The return on capital employed is 0.26 means that for every Rs 1 invested in capital employed, ABC company earns Rs 0.26
What does Return on Capital Employed tell investors?
ROCE tells you how efficiently the company utilizes its capital. Normally, companies with stable and rising ROCE are favoured by investors.
A higher ROCE ratio reflects the capital employed in the business operations, generating higher returns for a company. Thus, it indicates a good managerial ability and profitability of the firm.
A lower return on capital employed reveals managerial incompetence regarding the utilization of operating earnings and a company is not able to utilize its total capital most effectively.
The ratio should be higher than weighted average cost of capital, the company is creating profit and the shareholders will be benefited. The shareholders will stay invested in the company.
ROCE is less than WACC, it jeopardizes shareholders wealth because the company has to pay interest to the debt holders. The borrowing capital can eat shareholders earnings.
Let's understand with an example, ABC company's ROCE is 13% and cost of capital is 13%.
Thus, all the earnings are demolished by interest. Hence, a smart investor should be avoiding these types of companies. ROCE should be higher than the Cost of capital.
In general, investors can also see the trend of ROCE over the years for analysis of the company. It is more useful when comparing the performance of companies in capital-intensive sectors, such as utilities, telecoms, manufacturing etc.
What are the differences between ROIC and ROCE?
When it comes to the company's ability to be profitable in terms of capital, ROIC and ROCE both are used to analyse the company.
The two ratios, which are ROIC and ROCE, are almost similar and they furnish a gauge of profitability per total capital of the company.
The ROIC and ROCE should be higher than the weighted average cost of capital (WACC), so that company can be profitable in the long run.
ROIC stands for return on invested capital. ROIC is a calculation, which enables to examine a company's efficiency at using its capital for profitable investment.
The formula of return on capital invested is given below:
ROIC = (Earnings Before Interest and tax / Invested Capital)
Some analysts or investors may also take net profit after tax. Invested capital in the ROC calculation is somewhat more problematic than the general calculation for the capital employed used in the ROCE.
Therefore, invested capital is the capital that is working for the company.
Invested Capital = Capital Employed - Idle funds in bank/cash
However, the invested capital provides more insight information of the overall capital of a company.
Significance of Return on Capital Employed
Return on Capital Employed indicates a company's profitability and how efficiently it uses its total capital employed in its business operations.
The ROCE has some significance despite its many uses.
1. The ROCE ratio helps to find out the most profitable company in the market.
Hence, this ratio enables an investor to make investment decisions.
2. Mostly ROCE is more useful in capital intensive companies such as manufacturing, steel manufacturing etc.
3. ROCE is helpful to compare companies within a similar sector.
4. ROCE is an important ratio that evaluates a company's financial performance and stability in the long term which helps the potential investors making an investment decision.
What is a good ROCE ratio?
ROCE ratio has no ideal industry standard and also may depend on the nature of a business. A higher return on capital employed indicates a more profitable company.
Also, a higher number may be expressive that a company has a bunch of cash on hand since the cash is encompassed in total assets.
Limitations of Return on Capital Employed
Like other financial ratios, the return on capital employed has several limitations that investors should be aware of The limitations are following:
1. The only use of ROCE as a single measure of a company's performance is not sufficient, it will only deliver insight into the use of company capital.
Therefore, it is forever recommended to the ROCE ratio with other financial ratios to make reasonable investment decisions.
2. ROCE may not last for years and it will fluctuate year after year. It depends on the annual performances of the company in the market.
However, it is important to remark that the ROCE trends over the many years when correlating various companies.
3. It is helpful to compare the performances of two companies within the same industry but ROCE does not furnish proper information when comparing companies of several industries.
Conclusion
1 Higher return on capital employed ratio is considered to be more profitable and good financial health of a company.
2. Do not use a single ratio and also evaluate others' ratios such as return on equity, return on assets etc.
3. A company's returns should always be higher than the cost of debt capital because borrowing funds may spoil shareholders profits.
4. Famous investors like Warren Buffet or Peter Lynch pay a lot of attention to ROCE.
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