Brief on Return on Capital Employed (ROCE)
Return on Capital Employed (ROCE) is one of the business profitability measures that evaluates the rate of profitability with the resources employed in the process.
Valuation looks at the efficiency of creating profits compared to the capital employed.
As it has already been said, ROCE is widely used to access the quality of the firms’ financials and their efficiency in the operations they perform, and comparing to other companies in the same industry.
ROCE Formula and Calculation
The formula to calculate ROCE is:
ROCE = EBIT / Capital Employed
Where:
- EBIT means the operating profit that excludes the results of the financial structure and corporate tax.
Capital Employed is the total capital that is tied up in the concern. It can be calculated as:
- Total capital employed = total assets – Current liabilities
- Capital Employed = Equity Share Capital + Non-Current Borrowing Liabilities (long term borrowings).
Steps to Calculate ROCE:
- Get the EBIT from the company Income Statement.
- It can be easily found out by capital employed along with the help of the balance sheet.
- It can be derived by dividing EBIT by capital employed. And, this value is then multiplied by the factor of 100 so that percentage figure is derived.
Advantages of ROCE
Profitability Measure:
- ROCE is an improved comprehensive measure of a company’s profitability. This reveals the capability to make profits for the business out of the total capital available for investment.
Operational Efficiency:
- ROCE is similar to another efficiency measure, EBIT, in that it measures operating efficiency without regards to taxes or interest expenses.
Comparative Tool:
- The main limitation is that ROCE is most appropriate when it is used to compare firms with similar industries because it reveals fluctuations in capital exploitation.
Long-term Viability:
- It gives clues on the future viability of a business since it concerns the returns from capital employed.
Investor Confidence:
- High; ROCE assures investors of high performance, and the effective utilization of the limited available resources.
Interpretation of ROCE
- High ROCE: ROCE is an indication of how much profit a company is making from its capital since a high ROCE is desired. For example, any rate of return on capital employed of 20% and above is generally considered good.
- Low ROCE: A goods ROCE signifies poor bargaining power of capital, that is capital is being poorly utilized. This could definitely be/would be one sign of concern for every investor.
- Industry Benchmark: The analysis of ROCE should always be done in reference to the industry levels. The typical ROCE varies significantly based on industry capital intensity to reflect corporate performance.
- Consistency: High and steady ROCE from the past years to present demonstrates the efficiency of management in utilizing the resources available.
Applications of ROCE
Investment Decision-Making:
- They use ROCE to measure probable returns on their investments in the firm in relation to the capital intensity of the enterprise.
Performance Analysis:
- Management can use ROCE to ascertain which capital will yield poor returns then rearrange capital for optimal returns.
Benchmarking:
- Evaluating the market position and operational performance of a certain firm is done with help of comparison of the computed ROCE with the results of the competitors.
Strategic Planning:
- Businesses can use ROCE to decide on long term targets and objectives, and, thus, to allocate resources effectively.
Drawbacks of ROCE
Ignores Tax and Debt Costs:
- Like ROC, ROCE is computed using EBIT means it omits interest and tax, although they are strategic cost implications.
Static Measure:
- One of ROCE’s main weaknesses is that it gives information only at a specific moment which means that markets performance by its help does not predict future performance.
Impact of Depreciation:
- Companies with old fixed assets especially with low depreciation may have high ROCE while new companies with high fixed assets may be rated low in efficiency.
Capital-Intensive Industries:
- ROCE may not be suitable for the comparison with industries that by their nature are capital intensive, e.g., utilities or manufacturing.
Limited Insight:
- Free cash flow valuation does not incorporate external factors like current market position, competitors, or the overall economy that would affect results.
Example Application of ROCE
Scenario:
Firms A and B are two firms which operate in the same business sector. Their financial data is as follows:
| Metrics | Company A | Company B |
| EBIT | 1,20,000 | 90,000 |
| Total Assets | 5,00,000 | 4,50,000 |
| Current Liabilities | 1,00,000 | 50,000 |
Calculating ROCE
Capital Employed = Total Capital – Reserve and Surplus Capital employed
ROCE = Profit earned by capital employed / total capital employed × 100
Company A:
Capital Employed = 5,00,000 – 1,00,000 = 4,00,000
ROCE = (1,20,000 / 4,00,000) * 100 = 30%
Company B:
Capital Employed = 4,50,000 – 50,000 = 4,00,000
ROCE = (90,000 / 4,00,000) *100 = 22.5%
Interpretation:
- ROCE for Company A is better than that of Company B ROCE 30& for A and 22:5% for B, better utilize capital to generate profit. Company A would also benefit because its results could make Company A appear more attractive to stakeholders.
Conclusion
Return on Capital Employed is, in no doubt one of the most important measures to measure profitability business and its effectiveness while utilizing capital.
It also provides useful information to the investors, managers and all the other users. Despite the limitations such as exclusion of tax and debt expenses, ROCE remains an essential mechanism in valuing organizational performance as well as in planning and executing organizational strategies.
Knowing the formula for calculating the ROCE and the strategy of including this element in examining the company, may enable companies to undertake investment and financing opportunities that are better at accelerating the economic development of the companies and also profitability of investments.
Frequently Asked Questions
1.Why is ROCE important when we also have ROE and ROA metrics?
Some analysts prefer return on capital employed over return on equity (ROE) and return on assets (ROA) because it considers both debt and equity financing and is a better predictor of a company’s performance or profitability over a longer period of time.
2. What is a good ROCE value?
Although no standard exists in an industry, a higher return on capital used means at least that it is a more capital-efficient firm.
A bigger number, by contrast, could reflect a firm holding much cash because cash comprises part of total assets. Accordingly, sometimes big cash balances skew this measure to be much larger than necessary.
3. What does it mean to say that capital is being used?
They will use the cash in conducting their daily operations and using them as well to invest in new prospects or in expansion. Capital employed refers to the total of the firm’s assets minus current liabilities.
It is useful to analyze the capital used because together with other measures, the return on a firm’s assets and how efficiently capital deployment can be done by its management can be determined.