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

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Components of 'Return On Capital Employed (ROCE)'

ROCE is a useful metric for comparing profitability across companies based on the amount of capital they use. There are two metrics required to calculate the Return on Capital Employed - earnings before interest and tax and capital employed. Earnings before interest and tax (EBIT), also known as operating income, shows how much a company earns from its operations alone without regard to interest or taxes. EBIT is calculated by subtracting cost of goods sold and operating expenses from revenues.

Capital employed is the total amount of capital that a company has utilized in order to generate profits. It is the sum of shareholders' equity and debt liabilities. Also, it can be simplified as total assets minus current liabilities. Instead of using capital employed at an arbitrary point in time, analysts and investors often calculate ROCE based on the average capital employed, which takes the average of opening and closing capital employed for the time period.

Practical Example of ROCE

Consider two companies, Colgate-Palmolive Company and Procter & Gamble, which operate in the same industry sector. The table below shows the ROCE of both companies for fiscal year ended December 31, 2016 and June 30, 2017, respectively.

 (in millions) Colgate-Palmolive Company Procter & Gamble Sales \$15,195 \$65,058 EBIT \$3,837 \$13,955 Total Assets \$12,123 \$120,406 Current Liabilities \$3,305 \$30,210 Capital Employed \$8,818 \$90,196 TA - CL Return on Capital Employed 0.4351 0.1547 EBIT/Capital Employed

Instead of just looking at the revenue generated by each company, the capital employed by both companies should be compared. Although Procter & Gamble had more sales for the year and more assets, in terms of value, Colgate-Palmolive's ROCE of 43.51% is higher than P&G's 15.47% ROCE. This means that Colgate-Palmolive does a s better job of deploying its capital than P&G. 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.

Using the Return on Capital Employed

ROCE is especially useful when comparing the performance of companies in capital-intensive sectors such as utilities and telecoms. This is because unlike other fundamentals such as 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.

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