Return on capital employed (ROCE) and return on investment (ROI) are two profitability ratios that go beyond a company's basic profit margins to provide a more detailed assessment of how successfully a company runs its business and returns value to investors.
In particular, both examine the company in terms of how efficiently it utilizes capital to operate, invest and grow. ROCE and ROI, along with other evaluations, can be helpful to investors assessing a company's current financial condition and its ability to generate future profits.
ROCE examines how efficiently a company uses available capital with the following equation:
ROCE = Earnings before interest and tax (EBIT) / Capital employed
Capital employed is, in the simplest terms, the total amount of the firm's assets minus current liabilities. It's synonymous with available capital from net profits. The higher the value derived using the above formula, the more efficiently the company is utilizing its capital. It is critical that ROCE exceed the cost of capital—financing costs—or the company may be facing financial issues.
ROCE can be very useful for comparing the use of capital by different companies engaged in the same business, particularly in regard to capital-intensive industries such as energy companies, auto companies, and telecommunications firms.
For example, ABC Energy Co. generated $100 million in EBIT last year from its gas pipelines. The company has $750 million in total assets and current liabilities of $100 million. Its ROCE is 15.4%. Meanwhile, XYZ Oil Drillers Inc. generated $400 million in EBIT with $4 billion in assets and $200 million in current liabilities. XYZ has a ROCE of 10.5% despite making more in EBIT and having an asset base that’s nearly five times that of ABC. In short, ABC is more efficient at making money with its capital.
ROI is a popular profit metric used to evaluate company investments and their financial consequences with respect to cash flow. The formula for ROI results in a percentage, and is calculated as follows:
ROI = Profit from investment / Cost of investment
Any value greater than zero reflects net profitability, and higher values indicate more effective use of capital investment. A negative value is considered to be a major warning sign of extremely poor capital management.
ROI can be utilized by companies internally to evaluate the profitability of production of one product versus another, in order to determine which product's manufacturing and distribution represents the company's most efficient use of capital.
ROCE versus ROI
Both measures help determine the efficiency of how well a company utilizes its capital. ROCE is a more specific return measure than ROI, but it’s only useful when used with companies within the same industry. The numbers used must also cover the same period.
Unlike the ROCE, the ROI is a bit more flexible, as it can be used to compare products, but also projects and various investment opportunities. For example, an investor takes a $100,000 stake in a Company ABC. In five years the investor sells the stock for $125,000. The ROI for the investment would be 25%, or ($125,000 - $100,000) / $100,000.
The downfall of ROI is that it doesn’t take into account time. An investment can have the same ROI and yet one can provide that return in a year, while another takes a decade. The ROI calculation also doesn’t take into account fees or taxes.