Companies use different financial tools to help them understand their progress and calculate their profit or losses. Also, such tools help investors decide if a company is good to invest in. Accounting ratios are one of the financial ratios that help investors evaluate the overall company’s financial health. This article will discuss return on capital employed (ROCE) and its formula, importance, and limitations.
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What is Return on Capital Employed (ROCE)?
Return on capital employed or ROCE is a financial metric that measures how efficiently the company uses its capital to generate profits. In other words, this ratio indicates how much profit a company generates by each rupee employed. Thus, it helps to analyse the profitability and capital efficiency of a company.
ROCE is one of the most popular profitability ratios. Financial managers, stakeholders and potential investors commonly use this ratio while analysing a company for investment. Also, this is a long term profitability ratio because it indicates how effectively the assets are performing, considering long term financing. Hence, it can be helpful to evaluate the longevity of a company.
The return on capital employed should be higher than the cost of capital for a company to remain operating for a long time. Otherwise, it might gradually reduce the earnings available to the shareholders. Moreover, investors consider ROCE over ROE (return of capital) because ROE only analyses the profitability related to shareholders equity. In contrast, ROCE considered equity and debt, which can be helpful for company financial performance analysis.
Return on Capital Employed Formula
Return of capital employed (ROCE) is calculated by dividing the company’s net operating profit by its capital employed. The net operating profit is also known as EBIT or Earnings Before Interest and Taxes. The following is the formula to calculate ROCE –
ROCE = Earnings Before Interest & Taxes or EBIT/Capital Employed
EBIT – is deducting the cost of goods sold and operating expenses from total revenue. It is also referred to as operating income. It indicates how much profit a company generates from its operations alone, excluding interest and taxes.
Capital Employed – is very similar to invested capital. You can calculate it by deducting current liability from total assets or fixed assets plus working capital. Also, some analysts use average capital employed to compute ROCE, which is the average opening and closing capital employed for a time period under analysis.
Capital Employed = Total Assets – Current Liabilities.
Let’s assume company ABC has net operating earnings of Rs.5 lakhs in the income statement. The total assets appear as Rs.45 lakhs and current liabilities as Rs.2 lakhs on the balance sheet. What is the ROCE?
Return on Capital Employed (ROCE) = 500,000/(45,00,000 – 200,000)
Return on Capital Employed (ROCE) = 11.67%
Recommended Read: What is Operating Profit Ratio?
Interpretation of Return on Capital Employed (ROCE)
The potential investors consider ROCE as one of the parameters for investment. It shows the company’s likelihood to generate returns on the capital invested. The following is the interpretation and importance of using ROCE –
- A higher ratio is favourable because the company generates more profits on each rupee of capital invested. However, sometimes a higher ratio may also indicate higher cash in hand since it is a part of total assets. As a result, higher cash reserves may skew this metric as this cash is technically not employed yet.
- Investors use the ROCE ratio to compare companies within the same sector or industry. This is helpful to determine which company spends its money most effectively to create healthy returns.
- ROCE is useful for comparing capital-intensive companies that require heavy capital for their operations. For example – automobiles, trains, steel producers, etc. Since these companies have a significant investment, smart utilisation of money may prove a profitable investment for the potential investor.
- Measuring the financial efficiency of a company through ROCE is very helpful because it calculates profitability after deducting the amount of capital required.
- ROCE is not just a valuable measure for investors but also for companies as it helps them assess their performance, identify their strengths and problems, allowing them to work on performance development. Also, it helps companies for trend analysis where increasing ROCE implies strengthening long term profitability.
Limitations of Using Return on Capital Employed
Like any other accounting ratio, ROCE also has certain limitations despite its uses –
- One of the major drawbacks of using the ROCE ratio is that although it is useful for comparing the financial performance of two companies within the same industry, it does not provide precise data while comparing companies of different industries.
- Using ROCE as a single metric for performance measure is not effective as it only provides insight into a company’s capital usage. Thus, combining ROCE with other financial ratios is advisable to make better investment decisions.
- Companies with unused cash reserves show lower ROCE, impacting the actual result and overall decision. Therefore, ROCE is not the right measure for companies with sizable and unused cash reserves.
- ROCE cannot be constant throughout a period of years, and it can vary year on year depending on the company’s annual performance. Hence, studying the ROCE patterns over the past is important while comparing different companies.
Therefore, return on capital employed is a useful financial metric to identify companies that use their capital efficiently. It is very helpful for investors for comparing performance in a particular industry. However, it cannot provide a complete picture of a company’s financial health. Combing it with other accounting ratios gives an accurate insight into a company’s performance.
Frequently Asked Questions
The more your ROCE, the better it is. A higher ROCE suggests that a greater proportion of your company’s worth can be repaid as profit. A good ROCE largely depends on the size of the firm. Ideally, it should be at least double the current interest rates.
ROE considers the entire accounting profits in proportion to shareholders’ funds (net income and total equity), whereas ROCE focuses on operating profits and total assets, both debt and equity. This makes ROCE relevant for evaluating the efficiency of organizations where debt is a significant part of their capital structure.
A high ROCE shows that a greater proportion of profits can be reinvested in the business for shareholder’s benefit. Reinvested capital is employed at a higher rate of return that ultimately contributes to the growth of earnings per share. Therefore, a high ROCE indicates good growth.
ROCE should be at least double the current interest rates. This indicates a company’s efficiency in capital utilization. A high and constant ROCE might be indicative of a very successful business, as it indicates that a company continually makes excellent use of its resources. Ideally, a company with a higher ROCE than its category average is a good one.
In comparison to a company with a ROCE of 10%, a company with a ROCE of 20% may appear favourable. However, if the industry benchmark is 35%, both companies may seem to have a bad ROCE.
A good ROCE constitutes how effectively the assets are performing, considering long-term financing. A good ROCE should be higher than the cost of capital for a company. Furthermore, ROCE considers equity and debt to determine the profitability of the company. Thus, it gives a realistic indication of the company’s performance.
Return on Assets (ROA) focuses only on the efficient use of assets. Return on Equity (ROE) analyses the profitability related to shareholder’s equity. In contrast, Return on Capital Employed (ROCE) considers both equity and debt. Thus, it is helpful in measuring how efficiently the company is using its capital to generate profits.