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
“Capital Employed” as shown in the denominator is the sum of shareholders' equity and debt liabilities; it can be simplified as (Total Assets – Current Liabilities). Instead of using capital employed at an arbitrary point in time, analysts and investors often calculate ROCE based on “Average Capital Employed,” which takes the average of opening and closing capital employed for the time period.
A higher ROCE indicates more efficient use of capital. ROCE should be higher than the company’s capital cost; otherwise it indicates that the company is not employing its capital effectively and is not generating shareholder value.
BREAKING DOWN 'Return On Capital Employed (ROCE)'
ROCE is a useful metric for comparing profitability across companies based on the amount of capital they use. Consider two companies, Alpha and Beta, which operate in the same industry sector. Alpha has EBIT of $5 million on sales of $100 million in a given year, while Beta has EBIT of $7.5 million on sales of $100 million in the same year. On the face, it may appear that Beta should be the superior investment, since it has an EBIT margin of 7.5% compared with 5% for Alpha. But before making an investment decision, look at the capital employed by both companies. Let’s assume that Alpha has total capital of $25 million and Beta has total capital of $50 million. In this case, Alpha’s ROCE of 20% is superior to Beta’s ROCE of 15%, which means that Alpha does a better job of deploying its capital than Beta.
ROCE is especially useful when comparing the performance of companies in capital-intensive sectors such as utilities and telecoms. This is because unlike return on equity (ROE), which only analyzes 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 favor companies with stable and rising ROCE numbers over companies where ROCE is volatile and bounces around from one year to the next.
Read more on how ROCE can be an effective analysis tool - Spotting profitability with ROCE.