What is Return On Capital Employed (ROCE)
Return on capital employed (ROCE) is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. ROCE is calculated as:
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
Return On Capital Employed – ROCE
Components of Return On Capital Employed (ROCE)
ROCE is a useful metric for comparing profitability across companies based on the amount of capital they use. There are two metrics required to calculate the Return on Capital Employed – earnings before interest and tax and capital employed. Earnings before interest and tax (EBIT), also known as operating income, shows how much a company earns from its operations alone without regard to interest or taxes. EBIT is calculated by subtracting cost of goods sold and operating expenses from revenues.
Capital employed is the total amount of capital that a company has utilized in order to generate profits. It is the sum of shareholders’ equity and debt liabilities. Also, it can be simplified as total assets minus current liabilities. Instead of using capital employed at an arbitrary point in time, analysts and investors often calculate ROCE based on the average capital employed, which takes the average of opening and closing capital employed for the time period.
Using the Return on Capital Employed
ROCE is especially useful when comparing the performance of companies in capital-intensive sectors such as utilities and telecoms. This is because unlike other fundamentals such as return on equity (ROE), which only analyses profitability related to a company’s common equity, ROCE considers debt and other liabilities as well. This provides a better indication of financial performance for companies with significant debt.
Adjustments may sometimes be required to get a truer depiction of ROCE. A company may occasionally have an inordinate amount of cash on hand, but since such cash is not actively employed in the business, it may need to be subtracted from the Capital Employed figure to get a more accurate measure of ROCE.
For a company, the ROCE trend over the years is also an important indicator of performance. In general, investors tend to favour companies with stable and rising ROCE numbers over companies where ROCE is volatile and bounces around from one year to the next.