Profitability Indicator Ratios: Return On Capital Employed
AAA
  1. Profitability Indicator Ratios: Introduction
  2. Profitability Indicator Ratios: Profit Margin Analysis
  3. Profitability Indicator Ratios: Effective Tax Rate
  4. Profitability Indicator Ratios: Return On Assets
  5. Profitability Indicator Ratios: Return On Equity
  6. Profitability Indicator Ratios: Return On Capital Employed
Profitability Indicator Ratios: Return On Capital Employed

Profitability Indicator Ratios: Return On Capital Employed

By Richard Loth (Contact | Biography)

The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base.

By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management's ability to generate earnings from a company's total pool of capital.

Formula:


Components:


As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net income of $732.50 (income statement). The company's average short-term and long-term borrowings were $366.60 and the average shareholders' equity was $4,312.70 (all the necessary figures are in the 2004 and 2005 balance sheets), the sum of which, $4,679.30 is the capital employed. By dividing, the equation gives us an ROCE of 15.6% for FY 2005.

Variations:
Often, financial analysts will use operating income (earnings before interest and taxes or EBIT) as the numerator. There are various takes on what should constitute the debt element in the ROCE equation, which can be quite confusing. Our suggestion is to stick with debt liabilities that represent interest-bearing, documented credit obligations (short-term borrowings, current portion of long-term debt, and long-term debt) as the debt capital in the formula.

Commentary:
The return on capital employed is an important measure of a company's profitability. Many investment analysts think that factoring debt into a company's total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal. Investors would be well served by focusing on ROCE as a key, if not the key, factor to gauge a company's profitability. An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate.

Unfortunately, there are a number of similar ratios to ROCE, as defined herein, that are similar in nature but calculated differently, resulting in dissimilar results. First, the acronym ROCE is sometimes used to identify return on common equity, which can be confusing because that relationship is best known as the return on equity or ROE. Second, the concept behind the terms return on invested capital (ROIC) and return on investment (ROI) portends to represent "invested capital" as the source for supporting a company's assets. However, there is no consistency to what components are included in the formula for invested capital, and it is a measurement that is not commonly used in investment research reporting.

Proceed to the next chapter on Debt Ratios here.
Or, click here to return to the Financial Ratio Tutorial main menu.


  1. Profitability Indicator Ratios: Introduction
  2. Profitability Indicator Ratios: Profit Margin Analysis
  3. Profitability Indicator Ratios: Effective Tax Rate
  4. Profitability Indicator Ratios: Return On Assets
  5. Profitability Indicator Ratios: Return On Equity
  6. Profitability Indicator Ratios: Return On Capital Employed
Profitability Indicator Ratios: Return On Capital Employed
RELATED TERMS
  1. Lean Enterprise

    A production and management philosophy that considers any part ...
  2. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders ...
  3. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  4. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  5. Bid Wanted

    An announcement by an investor who holds a security that he or ...
  6. Bear Fund

    A mutual fund designed to provide higher returns when the market ...
  1. What are the differences between operating expenses and overhead expenses?

    Learn how operating expenses and overhead expenses affect profit margins; businesses are unique and different costs may fall ...
  2. What does an income statement look like?

    Learn about the different parts of an income statement and how investors review them carefully to determine the health of ...
  3. What is the difference between an income statement and a balance sheet?

    Find the current value of a business by reading the balance statement and determine whether operations are efficient by analyzing ...
  4. How is revenue related to retained earnings?

    Learn what business revenue is and how it relates to retained earnings. See how accountants calculate these key figures and ...
comments powered by Disqus
Related Tutorials
  1. Industry Handbook
    Investing Basics

    Industry Handbook

  2. Investing For Safety and Income Tutorial
    Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Discounted Cash Flow Analysis
    Fundamental Analysis

    Discounted Cash Flow Analysis

  4. Ratio Analysis Tutorial
    Fundamental Analysis

    Ratio Analysis Tutorial

  5. American Depositary Receipt Basics
    Economics

    American Depositary Receipt Basics

Trading Center