

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 shortterm and longterm 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 interestbearing, documented credit obligations (shortterm borrowings, current portion of longterm debt, and longterm 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.



Dividend
A distribution of a portion of a company's earnings, decided ... 
Sharpe Ratio
A ratio developed by Nobel laureate William F. Sharpe to measure ... 
Investment Income Ratio
The ratio of an insurance company’s net investment income to ... 
Combined Ratio
A measure of profitability used by an insurance company to indicate ... 
Policyholder Dividend Ratio
The policyholder dividend ratio is a measurement of the profitability ... 
Return On Policyholder Surplus
The ratio of an insurance company’s net income to its policyholder ...

What information should I look at on a publicly traded company for use in fundamental ...
Learn what information is important in fundamental analysis of a publicly traded company and how to use it to assess the ... 
Why is it important for an investor to understand business accounting?
Learn to understand why it is important for an investor to understand business accounting to perform investment and credit ... 
How is an accrued interest entry made in accounting?
Learn how to create common journal entries for accrued interest, including adjusting entries and delayed bond issues sold ... 
What is the formula for calculating EBITDA?
Learn about EBITDA and how companies can manipulate this calculation to look more profitable.