The term return on capital employed (ROCE) refers to a financial ratio that can be used to assess a company’s profitability and capital efficiency. This ratio helps understand how well a company is generating profits from its capital as it is put to use. ROCE is a key metric for financial managers, stakeholders, and potential investors analyzing a company for investment.
Key Takeaways
- ROCE is a financial ratio that measures a company’s profitability in terms of its total capital.
- It is similar to return on invested capital but includes debt and equity.
- It’s beneficial to compare the ROCE of companies within the same industry.
- Higher ratios typically indicate that companies are more profitable.
- Important related financial ratios include ROE, ROA, ROIC, and ROCE itself.
Understanding Return on Capital Employed (ROCE)
ROCE is particularly insightful when comparing the performance of companies in capital-intensive sectors like utilities and telecoms. Unlike return on equity (ROE), which only analyzes profitability related to a company’s shareholders’ equity, ROCE includes both debt and equity. This helps neutralize financial performance analysis for companies with substantial debt, thereby offering a comprehensive view of profitability.
ROCE calculates the amount of profit a company generates per dollar of capital employed. A higher ROCE indicates stronger profitability across company comparisons. Investors favor stable and rising ROCE trends over volatility or declining ROI levels.
How to Calculate ROCE
The formula for ROCE is:
ROCE = EBIT / Capital Employed
Where,
EBIT = Earnings before interest and tax
Capital Employed = Total assets − Current liabilities
EBIT, also known as operating income, indicates a company’s earnings from operations without considering interest on debt or taxes. Capital employed is calculated by subtracting current liabilities from total assets. Some analysts may prefer using average capital employed for more precise evaluations.
Components of ROI Calculation:
- Earnings Before Interest and Tax (EBIT): Shows earnings from core operations excluding interest on debts or taxes.
- Capital Employed: Derived from subtracting current liabilities from total assets, reflecting overall capital within the company.
Advantages and Disadvantages of ROCE
Pros of ROCE
- Holistic Performance Indicator: Combines profitability and capital efficiency to provide a comprehensive measure.
- Investor Confidence: Strong ROCE reflects superior returns and can attract potential investors.
- Performance Assessment Tool: Assists management in evaluating business units and resource allocation.
- Comparability: Offers value across different industries for uniform evaluation.
Cons of ROCE
- Limited Cross-Industry Comparability: Varies significantly across diverse industries.
- Historical Focus: Past data may not accurately predict future prospects.
- Ignores Capital Structure: Doesn’t consider the impact of debt vs. equity financing.
- Incomplete Financial Performance: Neglects elements like cash flow and margins.
- Prone to Manipulation: Can be tweaked through creative accounting practices.
Strategies for Improving ROCE
- Operational Efficiency: Streamline and optimize operations to reduce costs and increase productivity.
- Effective Capital Allocation: Prioritize high-return projects and align investments with strategic objectives.
- Asset Optimization: Utilize assets to their full potential, renegotiate leases, and sell underperforming assets.
- Revenue Growth Strategies: Focus on expanding market share, developing innovative products, and fostering customer relationships.
- Continuous Monitoring: Regularly evaluate performance and make necessary adjustments to maintain and improve ROCE.
ROCE and Business Cycles
Economies and industries go through different phases, affecting ROCE accordingly:
- Expansionary Phase: Higher demand and advantageous markets yield better ROCE.
- Peak Phase: Slowing growth dampens ROCE, making it stabilize or drop slightly.
- Contraction Phase: Falling demand and rising costs reduce ROCE.
- Recovery Phase: Gradual improvement in ROCE as the economy recovers.
- Early Growth Phase: Fluctuations in ROCE due to new investments during economic recovery.
Comparing ROCE and ROIC
ROCE and ROIC both evaluate profitability against total capital but vary slightly. ROIC considers Net Operating Profit After Tax ÷ Invested Capital, while ROCE focuses on EBIT and capital employed. For meaningful measurement, both should outperform the company’s weighted average cost of capital (WACC).
Example of ROCE
ACE Corp. vs. Sam & Co.
Consider two comparable companies in the same industry. The table below illustrates the ROCE calculation:
| Metric | ACE Corp. | Sam & Co. |
|---|---|---|
| Sales | $15,195 | $65,058 |
| EBIT | $3,837 | $13,955 |
| Total Assets | $12,123 | $120,406 |
| Current Liabilities | $3,305 | $30,210 |
| Capital Employed | $8,818 | $90,196 |
| ROCE | 43.51% | 15.47% |
ACE Corp., despite being smaller, operates more efficiently regarding capital employment compared to Sam & Co.
Summary
ROCE is a versatile and informative financial metric that assists in understanding a company’s profitability and capital efficiency. Utilizing ROCE along with other financial ratios provides a comprehensive view of a company’s performance, essential for making informed investment decisions.
Related Terms: Return on Equity, Return on Assets, Return on Invested Capital, Weighted Average Cost of Capital.
