What Is Return on Capital Employed (ROCE)?
The term return on capital employed (ROCE) refers to a financial ratio that can be used to assess a company's profitability and capital efficiency. In other words, this ratio can help to understand how well a company is generating profits from its capital as it is put to use. ROCE is one of several profitability ratios financial managers, stakeholders, and potential investors may use when analyzing a company for investment.
Key Takeaways
- Return on capital employed is a financial ratio that measures a company’s profitability in terms of all of its capital.
- ROCE is similar to return on invested capital.
- It's always a good idea to compare the ROCE of companies in the same industry as those from differing industries usually vary.
- Higher ratios tend to indicate that companies are profitable.
- Many companies may calculate the following key return ratios in their performance analysis: return on equity, return on assets, return on invested capital, and return on capital employed.
Understanding Return on Capital Employed (ROCE)
Return on capital employed can be 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 shareholders’ equity, ROCE considers debt and equity. This can help neutralize financial performance analysis for companies with significant debt.
Ultimately, the calculation of ROCE tells you the amount of profit a company is generating per $1 of capital employed. The more profit per $1 a company can generate, the better. Thus, a higher ROCE indicates stronger profitability across company comparisons.
For a company, the ROCE trend over the years can also be an important indicator of performance. Investors tend to favor companies with stable and rising ROCE levels over companies where ROCE is volatile or trending lower.
ROCE is one of several profitability ratios that can be used when analyzing a company’s financial statements for profitability performance. Other ratios can include the following:
- ROE
- Return on assets (ROA)
- Return on invested capital (ROIC)
Return on capital employed is also commonly referred to as the primary ratio because it indicates the profits earned on corporate resources.
How to Calculate ROCE
The formula for ROCE is as follows:
$\begin{aligned} &\text{ROCE} = \frac{ \text{EBIT} }{ \text{Capital Employed} } \\ &\textbf{where:}\\ &\text{EBIT} = \text{Earnings before interest and tax} \\ &\text{Capital Employed} = \text{Total assets } - \text{ Current liabilities} \\ \end{aligned}$
ROCE is a metric for analyzing profitability and for comparing profitability levels across companies in terms of capital. Two components are required to calculate ROCE. These are earnings before interest and tax (EBIT) and capital employed.
Also known as operating income, EBIT shows how much a company earns from its operations alone without interest on debt or taxes. It is calculated by subtracting the cost of goods sold (COGS) and operating expenses from revenues.
Capital employed is very similar to invested capital, which is used in the ROIC calculation. Capital employed is found by subtracting current liabilities from total assets, which ultimately gives you shareholders’ equity plus long-term debts. Instead of using capital employed at an arbitrary point in time, some analysts and investors may choose to calculate ROCE based on the average capital employed, which takes the average of opening and closing capital employed for the time period under analysis.
Return on Capital Employed (ROCE) vs. Return on Invested Capital (ROIC)
When analyzing profitability efficiency in terms of capital, both ROIC and ROCE can be used. Both metrics are similar in that they provide a measure of profitability per total capital of the firm. In general, both the ROIC and ROCE should be higher than a company’s weighted average cost of capital (WACC) in order for the company to be profitable in the long term.
ROIC is generally based on the same concept as ROCE, but its components are slightly different. The calculation for ROIC is as follows:
Net Operating Profit After Tax ÷ Invested Capital
Net operating profit after tax is a measure of EBIT x (1 – tax rate). This takes into consideration a company’s tax obligations, but ROCE usually does not.
Invested capital in the ROIC calculation is slightly more complex than the simple calculation for capital employed used in ROCE. Invested capital may be either:
Net Working Capital + Property Plant and Equipment (PP&E) + Goodwill and Intangibles
or
Total Debt and Leases + Total Equity and Equity Equivalents + Non-Operating Cash and Investments
The invested capital is generally a more detailed analysis of a firm’s overall capital.
Example of ROCE
Consider two companies that operate in the same industry: ACE Corp. and Sam & Co. The table below shows a hypothetical ROCE analysis of both companies.
(in millions) | ACE Corp. | Sam & Co. | |
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 |
As you can see, Sam & Co. is a much larger business than ACE Corp., with higher revenue, EBIT, and total assets. However, when using the ROCE metric, you can see that ACE Corp. is more efficiently generating profit from its capital than Sam & Co. ACE ROCE is 44 cents per capital dollar or 43.51% vs. 15 cents per capital dollar for Sam & Co., or 15.47%.
What Does It Mean for Capital to Be Employed?
Businesses use their capital to conduct day-to-day operations, invest in new opportunities, and grow. Capital employed refers to a company's total assets less its current liabilities. Looking at capital employed is helpful since it's used with other financial metrics to determine the return on a company's assets and how effective management is at employing capital.
Why Is ROCE Useful if We Already Have ROE and ROA Measures?
Some analysts prefer ROCE over return on equity and return on assets because the return on capital considers both debt and equity financing. These investors believe the return on capital is a better gauge for the performance or profitability of a company over a more extended period of time.
How Is Return on Capital Employed Calculated?
Return on capital employed is calculated by dividing net operating profit, or earnings before interest and taxes, by capital employed. Another way to calculate it is by dividing earnings before interest and taxes by the difference between total assets and current liabilities.
What Is a Good ROCE Value?
While there is no industry standard, a higher return on capital employed suggests a more efficient company, at least in terms of capital employment. However, a lower number may also be indicative of a company with a lot of cash on hand since cash is included in total assets. As a result, high levels of cash can sometimes skew this metric.
What Is a Good Percentage for Return on Capital Employed?
The general rule about ROCE is the higher the ratio, the better. That's because it is a measure of profitability. A ROCE of at least 20% is usually a good sign that the company is in a good financial position. But keep in mind that you shouldn't compare the ROCE ratios of companies in different industries. As with any financial metric, it's best to do an apples-to-apples comparison.
The Bottom Line
There are a number of different financial metrics that help analysts and investors review the financial health and well-being of different companies. You can use a company's return on capital employed to determine how profitable it is and how efficiently it uses its capital. You can easily calculate it using figures from corporate financial statements. But be sure to compare the ROCE of companies within the same industry as those from different sectors tend to have varying ratios. But it's generally a given that having a ratio of 20% or more means that a company is doing well.