Return on Capital Employed (ROCE)

Return on Capital Employed Definition

Return on Capital Employed (ROCE) is a profitability ratio that depicts the company’s ability to efficiently utilize its capital, which includes both debts as well as equity. It is calculated by dividing earnings before interest and tax (EBIT) to capital employed ( total assets – current liabilities). ROCE of 20% means that the company generates $20 for every $100 of capital employed.

ROCE-Formula

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Source: Return on Capital Employed (ROCE) (wallstreetmojo.com)

ROCE Formula

Let’s have a look at the Return on Capital Employed formula to have an understanding of how to calculate the profitability –

Return on Capital Ratio Formula = Net Operating Income (EBIT) / Capital Employed

Return on Capital Employed Calculation

We will look at each of the items and then calculate the ROCE.

We take two Return on Capital Employed examples. First, we will take the simplest one, and then we will show a bit complex example.

Example # 1

In US $Company ACompany B
EBIT30,00040,000
Total Assets300,000400,000
Current Liabilities15,00020,000
ROCE??

Also, look at this comprehensive Ratio AnalysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more” description=”Ratio analysis is the quantitative interpretation of the company’s financial performance. It provides valuable information about the organization’s profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.” url=”https://www.wallstreetmojo.com/ratio-analysis/”]Ratio AnalysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more[/wsm-tooltip] Guide with an excel case study on Colgate.

We already have EBIT given, but we need to calculate the difference between total assets and current liabilities to get the figure of capital employed.

In US $Company ACompany B
Total Assets (A)300,000400,000
Current Liabilities (B)15,00020,000
Capital Employed (A – B)285,000380,000

Now let’s calculate the ratio for both of these companies –

In US $Company ACompany B
EBIT (X)30,00040,000
Capital Employed (Y)285,000380,000
ROCE (X/Y)10.53%10.53%

From the above example, both of these companies have the same ratio. But if they are from different industries, they can’t be compared. If they are from a similar industry, it can be said that they are performing quite similarly for the period.

Example # 2

In US $Company ACompany B
Revenue500,000400,000
COGS420,000330,000
Operating Expenses10,0008,000
Total Assets300,000400,000
Current Liabilities15,00020,000
ROCE??

Here we have all the data for computation of EBIT and Capital Employed. Let’s first [wsm-tooltip header="Calculate EBIT" description="EBIT is a profitability tool used to measure the operating Profits of a Company. You can calculate it either by, EBIT = Gross Sales – Company Expenses & Cost of Goods Sold, Or, EBIT = Total Profit + Interest + Taxes." url="https://www.wallstreetmojo.com/ebit-calculation/"]calculate EBITCalculate EBITEBIT is a profitability tool used to measure the operating Profits of a Company. You can calculate it either by, EBIT = Gross Sales – Company Expenses & Cost of Goods Sold, Or, EBIT = Total Profit + Interest + Taxes.read more[/wsm-tooltip], and then we will calculate Capital Employed. Finally, by using both of these, we will ascertain ROCE for both of these companies.

Here’s the computation of EBIT –

In US $Company ACompany B
Revenue500,000400,000
(-)COGS(420,000)(330,000)
Gross Revenue80,00070,000
(-)Operating Expenses(10,000)(8,000)
EBIT (Operating Profit) (M)70,00062,000

Let’s now calculate the Capital Employed –

In US $Company ACompany B
Total Assets300,000400,000
(-)Current Liabilities(15,000)(20,000)
Capital Employed (N)285,000380,000

Let’s calculate Return on Capital Employed –

In US $Company ACompany B
EBIT (Operating Profit) (M)70,00062,000
Capital Employed (N)285,000380,000
ROCE (M/N)24.56%16.32%

From the above example, it’s clear that Company A has a higher ratio than Company B. If Company A and Company B are from different industries, then the ratio is not comparable. But if they are from the same industry, Company A is certainly utilizing its capital better than Company B.

How to Interpret ROCE?

If you compare between two or multiple companies, then you can interpret Return on Capital Employed as follows –

  • Check whether these companies are from similar industries. If they are from a similar industry, it makes sense to compare ROCE; otherwise, the comparison doesn’t create any value.
  • You need to see the period during which the statements are made to find out whether you are comparing the companies during the same period.
  • Find out the average ROCE of the industry to make sense of what you find.
  • If two companies have similar revenues but the different return on capital employed, the company which has a higher ratio would be better for investors to invest in.
  • And the company which has lower ROCE should be checked for other ratios as well. As no single ratio can depict the entire picture of a company, it’s advisable that before investing in any company, every investor should go through multiple ratios to come to a concrete conclusion.

Return on capital employed is a great ratio to find out whether a company is truly profitable or not.

Nestle Return on Capital Employed

Now let’s take an example from the global industry and find out ROCE from real data.

First, we will look at the income statement and balance sheet of Nestle for 2014 and 2015, and then we will calculate ROCE for each of the years.

Finally, we will analyze the ROCE ratio and would see the possible solutions Nestle can implement (if any).

Let’s get started.

Consolidated income statement for the year ended 31st December 2014 & 2015

Nestle Income Statement
Nestle- Balance Sheet

source: Nestle Annual Report

Here three figures are important, and all of them are highlighted. First is the Operating Profit for 2014 and 2015. And then, the total assets and total current liabilities for 2014 and 2015 are needed to be considered.

In millions of CHF
 20152014
Operating Profit (A)1240814019
Total assets123992133450
Total current liabilities3332132895

We know the EBIT or the operating profit. We need to calculate the capital employed –

In millions of CHF
  
 20152014
Total assets123992133450
(-)Total current liabilities(33321)(32895)
Capital Employed (B)90,671100,555

Now, let’s calculate the ratio.

In millions of CHF
 20152014
Operating Profit (A)1240814019
Capital Employed (B)90,671100,555
ROCE (A/B)13.68%13.94%

From the above computation, it’s clear that the ROCE of Nestle is almost similar in both of the years. As in the FMCG industry, the investments in assets are more; the ratio is quite good. We should not compare the ratios of the FMCG industry with any other industry. In the FMCG industry, capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more is much higher than in other industries; thus, the ratio would be less than in other industries.

Home Depot Return on Capital Employed

Home Depot is a retail supplier of home improvement tools, construction products, and services. It operates in the US, Canada, and Mexico.

Let us look at the trend of Return on Capital Employed for Home Depot in the below chart –

Home Depot

source: ycharts

We note that Home Depot ROCE increased from ROCE of ~ 15% in FY10 to ROCE of 46.20% in FY17. What led to such a phenomenal growth in Return on Capital Employed for Home Depot?

Let us investigate and find out the reasons.

Just to refresh,

Return on Capital Employed RatioNet Operating Income (EBIT) / (Total Assets – Current Liabilities)

The denominator of (Total Assets – Current Liabilities) can also be written as (Shareholder’s Equity + Non-Current Liabilities)

ROCE can increase either because of 1) an increase in EBIT, 2) a decrease in Equity 3) a Decrease in Non-Current Liabilities.

#1) Increase in EBIT

Home Depot EBIT has increased from $4.8 billion in FY10 to $13.43 billion in FY17 (an increase of 180% over 7 years).

Home Depot ROCE Calculation - EBIT increase

source: ycharts

EBIT increased the numerator significantly and is one of the most important contributors to the growth in ROCE.

#2 – Evaluating Shareholders Equity

Home Depot’s Shareholder’s Equity drastically declined from $18.89 billion in FY11 to $4.33 billion in FY17 (

We note that shareholder’s equity of Home Depot has decreased by 65% in the last 4 years. Declining shareholder’s equity has contributed to the decrease in the denominator of ROCE. With this, we note that the decrease in Shareholder’s Equity has also contributed meaningfully to the increase in Home Depot ratio

Home Depot ROCE - Shareholders Equity

source: ycharts

If we look at Home Depot’s Shareholder’s Equity section, we find the possible reasons for such a decrease.

  1. Accumulated Other Comprehensive LossOther Comprehensive LossOther comprehensive income refers to income, expenses, revenue, or loss not being realized while preparing the company's financial statements during an accounting period. Thus, it is excluded and shown after the net income.read more has resulted in the lowering of shareholders’ equity in both 2015 and 2016.
  2. Accelerated BuybacksAccelerated BuybacksAccelerated share repurchase (buyback) is a strategy adopted by a publicly-traded company to acquire its outstanding shares in the market from the clients in large blocks via an investment bank.read more were the second and most important reason for the decrease in Shareholder’s equity in 2015 and 2016.

#3 – Home Depot Debt

Let us now look at Home Depot’s Debt. We note that Home Depot debt increased from 9.682 billion in 2010 to $23.60 billion in 2016. This 143% increase in debt resulted in the lowering of the ROCE.

Home Depot ROCE Calculation - Debt Increase

source: ycharts

Summary of Home Depot ROCE Analysis

We note that Home Depot ratio increased from ratio of ~ 15% in FY10 to 46.20% in FY17 because of the following –

  1. EBIT increased by 180% over the 7 years (2010-2017). It significantly increases ratio due to an increase in the numerator
  2. Shareholder Equity decreased by 77% in the corresponding period. It significantly reduces the denominator, thereby increasing the ROCE.
  3. Overall, an increase in ratio because of the two factors above (1 and 2) was offset by the 143% increase in debt during the corresponding period.

Limitations

  • First, you can’t depend on ROCE alone because you need to calculate other profitability ratios to get the whole picture. Moreover, it is calculated on EBIT and not on Net Income, which can turn out to be a great disadvantage.
  • Second, ROCE seems to favor older companies because older companies are able to depreciate their assets more than newer companies! And as a result, for older companies, it becomes better.

Conclusion

In the final analysis, it can be said that ROCE is one of the best profitability ratios to consider while the investors decide upon the company’s profitability. But you need to keep in mind that it is not the only profitability ratio to consider. You can also take into account several ratios like Profit MarginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more” description=”Profit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. ” url=”https://www.wallstreetmojo.com/profit-margin/”]Profit MarginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more[/wsm-tooltip], Return on Invested Capital (ROIC), Return on Asset (ROA), Interpret ROE, etc.

ROCE Video

 

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Comments

  1. Miguel A. Rodríguez / MAR says

    Hi Vaidya-
    Could you correct the numbers in the first section of this blog?

    Says:
    Revenue for the year $33,00,000
    Should says:
    Revenue for the year $3,300,000 … you have a mistake with the puntation mark (,) … comma

    • Dheeraj Vaidya says

      thanks, Miguel. I made the changes.