Return on Capital Employed (ROCE): Ratio, Interpretation, and Example

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. In other words, this ratio can help to understand how well a company is generating profits from its capital as it is put to use. ROCE is one of several profitability ratios financial managers, stakeholders, and potential investors may use when analyzing a company for investment.

Return on capital employed can be 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 analyzes profitability related to a company’s shareholders’ equity, ROCE considers debt and equity. This can help neutralize financial performance analysis for companies with significant debt.

Ultimately, the calculation of ROCE tells you the amount of profit a company is generating per $1 of capital employed. The more profit per $1 a company can generate, the better. Thus, a higher ROCE indicates stronger profitability across company comparisons.

For a company, the ROCE trend over the years can also be an important indicator of performance. Investors tend to favor companies with stable and rising ROCE levels over companies where ROCE is volatile or trending lower.

ROCE is one of several profitability ratios that can be used when analyzing a company’s financial statements for profitability performance. Other ratios can include the following:

Return on capital employed is also commonly referred to as the primary ratio because it indicates the profits earned on corporate resources.

The formula for ROCE is as follows:

ROCE is a metric for analyzing profitability and for comparing profitability levels across companies in terms of capital. Two components are required to calculate ROCE. These are earnings before interest and tax (EBIT) and capital employed.

Also known as operating income, EBIT shows how much a company earns from its operations alone without interest on debt or taxes. It is calculated by subtracting the cost of goods sold (COGS) and operating expenses from revenues.

Capital employed is very similar to invested capital, which is used in the ROIC calculation. Capital employed is found by subtracting current liabilities from total assets, which ultimately gives you shareholders’ equity plus long-term debts. Instead of using capital employed at an arbitrary point in time, some analysts and investors may choose to calculate ROCE based on the average capital employed, which takes the average of opening and closing capital employed for the time period under analysis.

There are various reasons why companies should track ROCE. ROCE provides a comprehensive measure of a company's overall performance by considering both profitability and capital efficiency. It helps assess the effectiveness of capital allocation decisions and the ability to generate returns on invested capital. Therefore, ROCE allows for meaningful comparisons between companies operating in different industries and highlights a company's ability to generate profits from the capital it employs.

ROCE is an important metric for investors as it reflects the company's ability to generate returns on their investment. A consistently high ROCE indicates that the company is generating attractive returns, which can instill confidence in investors and potentially attract more capital.

ROCE also serves as a useful management tool for assessing the performance of different business units or projects within a company. It helps identify areas where capital may be tied up inefficiently and allows for better decision-making regarding resource allocation and investment strategies. More specifically, ROCE provides a long-term perspective on a company's profitability and efficiency. It considers the profitability generated over an extended period and relates it to the capital employed.

There are also many downsides to ROCE, each of which users must be aware of when analyzing ROCE calculations. Due to differences in capital intensity and business structures, ROCE may not be directly comparable across sectors. ROCE also primarily concentrates on profitability and capital efficiency, but it leaves out other crucial elements of financial performance including revenue growth, margins, the creation of cash flow, and return on equity.

Since ROCE is based on past financial data, it could not accurately reflect current market circumstances or growth possibilities. It is a reflection of previous capital investments' success and may not be a reliable predictor of future profitability or the potential effects of new investments. In addition, the effect of a company's capital structure, such as debt or equity financing, is not taken into account by ROCE.

ROCE is susceptible to manipulation through financial engineering and accounting techniques, just like any other financial indicator. It also may not take into account changes in the industry as a whole, changes in the economy, or other variables that may have an influence on a company's performance. Last, relying entirely on ROCE might result in a limited viewpoint and an inadequate evaluation of a company's current situation and future prospects.

Performance evaluation combining profitability and efficiency

Helps identify inefficient capital utilization

Boosts investor confidence in returns

Measures capital efficiency and allocation

Comparability across industries

Limited comparability across diverse industries

Historical focus may not reflect future prospects

Ignores the impact of capital structure

Does not capture complete financial performance

Susceptible to manipulation and accounting practices

Improving ROCE requires a strategic approach that focuses on enhancing profitability and capital efficiency. Companies can achieve this by streamlining operations, optimizing capital allocation, and continuous monitoring and evaluation. Operational efficiency involves streamlining and optimizing operations to reduce costs, improve productivity, and increase profitability. Companies often do this by enacting lean practices, automation, and process improvements. These solutions can eliminate waste and enhance efficiency.

Effective capital allocation also involves evaluating and prioritizing capital investment decisions. Companies can focus on projects with high potential returns and aligning investments with the company's strategic objectives. This also means prioritizing working capital management towards inventory, receivables, and payables, reducing inventory carrying costs and shortening receivables collection periods related to the most profitable projects.

Asset optimization also involves optimizing asset utilization to generate maximum returns. For example, companies can renegotiate leases, sell underutilized or non-performing assets, renegotiating leases and contracts, and exploring shared asset models. ROCE is improved when fewer capital is deployed; by avoiding unnecessary carrying costs or long-term investment expenses, companies can improve the returns it incurs.

Last, pricing and margins should be reviewed. Sales and revenue growth strategies should focus on expanding market share, developing innovative products, and strengthening customer relationships. Talent and skills development should be invested in employee training and development programs, while risk management should be mitigated to minimize negative impacts on ROCE. All of these solutions focus more on scaling the "return" aspect of ROCE.

It should go without saying that continuous monitoring and evaluation should be conducted to track progress and identify areas for improvement. Companies should tailor their strategies based on their specific industry, competitive landscape, and internal capabilities to achieve sustainable improvements in ROCE. As companies enact strategies to improve ROCE, it must be aware of unrelated repercussions that may have negative impacts elsewhere.

In many ways, ROCE is tied to changes during different economic cycles:

When analyzing profitability efficiency in terms of capital, both ROIC and ROCE can be used. Both metrics are similar in that they provide a measure of profitability per total capital of the firm. In general, both the ROIC and ROCE should be higher than a company’s weighted average cost of capital (WACC) in order for the company to be profitable in the long term.

ROIC is generally based on the same concept as ROCE, but its components are slightly different. The calculation for ROIC is as follows:

Net operating profit after tax is a measure of EBIT x (1 – tax rate). This takes into consideration a company’s tax obligations, but ROCE usually does not.

Invested capital in the ROIC calculation is slightly more complex than the simple calculation for capital employed used in ROCE. Invested capital may be either:

or

The invested capital is generally a more detailed analysis of a firm’s overall capital.

Consider two companies that operate in the same industry: ACE Corp. and Sam & Co. The table below shows a hypothetical ROCE analysis of both companies.

As you can see, Sam & Co. is a much larger business than ACE Corp., with higher revenue, EBIT, and total assets. However, when using the ROCE metric, you can see that ACE Corp. is more efficiently generating profit from its capital than Sam & Co. ACE ROCE is 44 cents per capital dollar or 43.51% vs. 15 cents per capital dollar for Sam & Co., or 15.47%.

Businesses use their capital to conduct day-to-day operations, invest in new opportunities, and grow. Capital employed refers to a company's total assets less its current liabilities. Looking at capital employed is helpful since it's used with other financial metrics to determine the return on a company's assets and how effective management is at employing capital.

Some analysts prefer ROCE over ROA and ROE because the return on capital considers both debt and equity financing. These investors believe the return on capital is a better gauge for the performance or profitability of a company over a more extended period of time.

Return on capital employed is calculated by dividing net operating profit, or earnings before interest and taxes, by capital employed. Another way to calculate it is by dividing earnings before interest and taxes by the difference between total assets and current liabilities.

While there is no industry standard, a higher return on capital employed suggests a more efficient company, at least in terms of capital employment. However, a lower number may also be indicative of a company with a lot of cash on hand since cash is included in total assets. As a result, high levels of cash can sometimes skew this metric.

The general rule about ROCE is the higher the ratio, the better. That's because it is a measure of profitability. A ROCE of at least 20% is usually a good sign that the company is in a good financial position. But keep in mind that you shouldn't compare the ROCE ratios of companies in different industries. As with any financial metric, it's best to do an apples-to-apples comparison.

There are a number of different financial metrics that help analysts and investors review the financial health and well-being of different companies. You can use a company's return on capital employed to determine how profitable it is and how efficiently it uses its capital. You can easily calculate it using figures from corporate financial statements. But be sure to compare the ROCE of companies within the same industry as those from different sectors tend to have varying ratios. But it's generally a given that having a ratio of 20% or more means that a company is doing well.