What Is Return On Capital Employed?

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ROCE is a metric that investors and other stakeholders use to check if the business would be a good investment option. The ratio is of the best use when generated to make an effective comparison between two companies to check which is more productive.

Key Takeaways

  • Return on Capital Employed (ROCE) is a profitability ratio that depicts the company’s ability to efficiently utilize its capital, including both debts and equity.If two companies have similar revenues but different returns on capital employed, the company with a higher ratio would be better for investors to invest in.ROCE is not the only financial ratio that companies can depend on.The ratio tends to help financial managers, potential investors, and other stakeholders to make well-informed business and investment decisions.

Return On Capital Employed Explained

Return On Capital Employed, as the name suggests, depicts the returns firms receive from the capital they employ. Also known as a primary ratio, the ROCE offers an idea about the profits against the resources the companies use. It is computed when net operating profit is divided by the capital employedCapital EmployedCapital employed indicates the company’s investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. “Capital Employed = Total Assets - Current Liabilities” or “Capital Employed = Non-Current Assets + Working Capital.“read more.

This net operating profit is the Earnings Before Interest and TaxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company’s operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization’s profit from business operations while excluding all taxes and costs of capital.read more (EBIT). The EBIT shows the income that a company generates and records before deducting the debts or taxes. It is calculated when the sum of the cost of goods sold (COGS) and operating expenses are subtracted from revenues.

On the other hand, the capital employed is the difference between total assetsTotal AssetsTotal Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more and current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They’re usually salaries payable, expense payable, short term loans etc.read more.

ROCE Interpretation

So far as the ROCE value is concerned, the higher this ratio, the better it is. Thus, comparing the profitability of two companies and finding out which one is more efficient in its working become easier.

However, the return on capital employed interpretation is reliable and justified only when the companies compared belong to the same industry. The comparison becomes invalid if the businesses differ in terms of structure, function, activities, and other aspects. In addition, if the companies have similar revenue figures with different capital employed, the higher ratio value shows a company is more profitable. Thus, investors know which company to invest in for more profits.

The comparison must be made for the same period the statements have been prepared. This makes the comparison accurate. Once the ROCE is obtained, the company knows how profitable it is. However, firms cannot rely on one financial statement to make major strategic decisions. Hence, they consider multiple documents to evaluate the firms’ productivity better.

Formula of ROCE

The return on the capital employed formula for calculating the financial ratio is expressed as:

Calculation Example

Let us take the following example to see how to calculate the return on capital employed:

Below are the financial detail Company A and B have:

Though the EBIT is mentioned, the capital employed must be figured out. As already known, capital employed is the difference between the total assets and current liabilities, and thus, it is easily calculated for both companies as shown below:

Now that the capital employed and EBIT are known, ROCE can be calculated as:

The ROCE, as depicted, is the same for both companies. Thus, they both are equally profitable. However, to be more accurate in making investment decisions, the stakeholders must also look into other financial ratios and statements.

Advantages & Disadvantages

The ROCE ratio helps companies understand how fruitful the capital used has been in earning them the returns they reaped. But simultaneously, the results turn invalid if certain parameters miss consideration. So, here is a list of advantages and disadvantages that one must be aware of:

Return on Capital Employed vs Return on Invested Capital vs Return on Equity

ROCE, return on invested capital, and return on equity are similar terms and might confuse people starting up with finance. However, there is a difference between these three. Let us check them out:

  • ROCE is the term that assesses a company’s return based on the capital it puts to use.Return on invested capital refers to the ratio that helps assess the ability of a company to allocate appropriate capital to profitable investments.Return on equity is the ratio that helps determine a business’s profitability with respect to the shareholder’s equity.

ROCE Video

This has been a guide to what is Return on Capital Employed. We explain its formula with a calculation example, advantages, disadvantages & vs ROE & ROIC. You can learn more about financing from the following articles –

The higher the ROCE, the better it is. The ratio calculated as 20% is considered good, indicating the company is more profitable and has a stable financial position in the market. However, for the calculation and comparison to be effective, one must consider companies from the same industry. If the companies from different sectors are taken for comparison, the results are not reflective of the real scenario.

The ROCE shows how profitable a company is with respect to the capital it employs to achieve the same. While comparing the two ROCEs, one must ensure the companies in consideration belong to the same industry.

The ROCE can be improved by reducing the costs incurred. First, the companies can cut costs where they think it is excessive or inefficient. This increases their operational efficiency. Secondly, the firms can increase sales by implementing various sales strategies. Finally, repaying debt and reducing liabilities of different forms also help improve the ROCE.

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