Return on capital employed (ROCE) is a good baseline measure of a company's performance. It is especially useful when comparing certain types of businesses. It is best employed in conjunction with other performance measures rather than looked at in isolation. ROCE is one of several profitability ratios used to evaluate a company's performance. It is designed to show how efficiently a company makes use of its available capital by looking at the net profit generated in relation to every dollar of capital utilized by the company.
The formula used to calculate ROCE is as follows:
ROCE=Capital EmployedEBITwhere:ROCE=Return on capital employedEBIT=Earnings before interest and tax
Some analysts use net profit rather than EBIT to do the calculation.
ROCE is a useful measure of financial efficiency since it measures profitability after factoring in the amount of capital used to create that level of profitability. Comparing ROCE to basic profit margin calculations can show the value of looking at ROCE.
ROCE Versus Basic Profit Margin Example
For example, consider two companies, one with a 10% profit margin and the other with a 15% profit margin. The second company appears to be performing better. However, if the second company uses twice as much capital to generate its profit, it is actually a less financially efficient company because it is not making maximum use of its revenues. A higher ROCE shows a higher percentage of the company's value can ultimately be returned as profit to stockholders. As a general rule, to indicate a company makes reasonably efficient use of capital, the ROCE should be equal to at least twice current interest rates.
ROCE is a useful metric of financial performance and has been shown to be particularly helpful in comparisons between companies engaged in capital-intensive industry sectors. It has gained a strong reputation as a benchmark financial tool for evaluating oil and gas companies. No performance metric is perfect, and ROCE is most effectively used with other measures, such as return on equity (ROE). ROCE is not the best evaluation for companies with large, unused cash reserves.