Return On Capital Employed Definition
Return On Capital Employed (ROCE) refers to the financial ratio that helps assess the return that a company or business generates with respect to the capital it puts to use. It is a determinant that lets businesses and people associated with them figure out how efficient and profit-bearing they are.
ROCE is a metric that investors and other stakeholders use to check if the business would be a good investment option. The ratio is of the best use when generated to make an effective comparison between two companies to check which is more productive.
Table of contents
- Return on Capital Employed (ROCE) is a profitability ratio that depicts the company’s ability to efficiently utilize its capital, including both debts and equity.
- If two companies have similar revenues but different returns on capital employed, the company with a higher ratio would be better for investors to invest in.
- ROCE is not the only financial ratio that companies can depend on.
- The ratio tends to help financial managers, potential investors, and other stakeholders to make well-informed business and investment decisions.
Return On Capital Employed Explained
The return on capital employed analysis, as the name suggests, depicts the returns firms receive from the capital they employ. Also known as a primary ratio, the ROCE offers an idea about the profits against the resources the companies use. It is computed when net operating profit is divided by the capital employedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital.".
This net operating profit is the Earnings Before Interest and TaxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital. (EBIT). The EBIT shows the income that a company generates and records before deducting the debts or taxes. It is calculated when the sum of the cost of goods sold (COGS) and operating expenses are subtracted from revenues.
On the other hand, to calculate return on capital employed, we find the difference between total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity and current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc..
The return on the capital employed formula for calculating the financial ratio is expressed as:
So far as the return on capital employed ratio value is concerned, the higher this ratio, the better it is. Thus, comparing the profitability of two companies and finding out which one is more efficient in its working become easier.
However, the return on capital employed interpretation is reliable and justified only when the companies compared belong to the same industry. The comparison becomes invalid if the businesses differ in terms of structure, function, activities, and other aspects. In addition, if the companies have similar revenue figures with different capital employed, the higher ratio value shows a company is more profitable. Thus, investors know which company to invest in for more profits.
The comparison must be made for the same period the statements have been prepared. This makes the comparison accurate. Once the ROCE is obtained, the company knows how profitable it is. However, firms cannot rely on one financial statement to make major strategic decisions. Hence, they consider multiple documents to evaluate the firms’ productivity better.
Let us take the following example to see how to calculate the return on capital employed:
Below are the financial detail Company A and B have:
|In US $||Company A||Company B|
Though the EBIT is mentioned, the capital employed must be figured out. As already known, capital employed is the difference between the total assets and current liabilities, and thus, it is easily calculated for both companies as shown below:
|In US $||Company A||Company B|
|Total Assets (A)||300,000||400,000|
|Current Liabilities (B)||15,000||20,000|
|Capital Employed (A – B)||285,000||380,000|
Now that the capital employed and EBIT are known, ROCE can be calculated as:
|In US $||Company A||Company B|
|Capital Employed (Y)||285,000||380,000|
The ROCE, as depicted, is the same for both companies. Thus, they both are equally profitable. However, to be more accurate in making investment decisions, the stakeholders must also look into other financial ratios and statements.
From the above example, we can interpret the meaning of the financial metric and calculate return on capital employed and learn how we can use the information given in the financial statements of a business to calculate the ratio. This will help the management, investors, creditors, and other stakeholders to analyze the financial health. But, as already stated above, return on capital employed ratio should be combined with other essential metrics for best results.
How To Improve?
Since this metric is extremely important from the point of view of both management and stakeholders who use it to evaluate the profitability in relation to the capital invested, it is necessary for the business to improve it so as to indicate good efficiency level and overall financial performance. Some approaches to do so as given below:
- Increase revenue and sales – The most effective way of increasing the ratio is to increase sales and earn higher revenue. For this, the products and services should be able to meet the required demand and should be of good quality that can meet the customer expectation. There should be innovation and analysis to understand changes in the market landscape to get a good return on capital employed.
- Increase profitability – Increase in sales will lead to increase in profits if the business is objectively focussed towards meeting customer requirements following an efficient operational process.
- Efficient use of resource – The resources should be properly utilized so that there is optimum usage without any wastage or losses. Every resource comes with cost of procurement and implementation. So they should be channelized in proper direction to increase overall business returns.
- Debt management – A business needs to borrow funds to finance its expenses and overall capital requirements so that it can grow, expand and invest in projects and assets that will bring returns. But it is necessary to maintain a balance between the earnings and debt level so that repayment does not become a burden. The management should understand the creditworthiness of the company and accordingly use debt financing to maximise returns.
- Control Cost – Cost control is an essential element in a business. If cost of operation is high, this takes away the profits, even if the revenue earned is very high. As an end result, very less funds are left aside to finance for long term and productive projects and investments that may yield good returns. Thus, it is important to keep cost under control.
- Customer satisfaction – This is another reason of increase returns on the capital that is employed in the business. Good customer satisfaction means good revenue, leading to increase in profitability and in turn returns on capital. It is important to understand the market trends, and focus on products after analysing the customer segments and then allocate resources accordingly.
- Monitoring and adjustment – Every business should monitor and assess the performance on regular basis. The return on capital employed analysis, this will help in understanding whether the strategies are able to meet the targets and achieve the objectives. Tracking regular progress will ensure the best possible return in assets and growth of business.
Thus, the above are some important approaches to improve the return on capital employed analysis.
Advantages & Disadvantages
The ROCE ratio helps companies understand how fruitful the capital used has been in earning them the returns they reaped. But simultaneously, the results turn invalid if certain parameters miss consideration. So, here is a list of advantages and disadvantages that one must be aware of:
|Offers value of monetary returns on debts and equity.||Might not reflect the market value|
|Helps investors make effective financial decisions||Risk of accounting manipulations|
|Enables comparisons between two companies from the same sector||Cannot be a single ratio considered for final decision-making|
Return On Capital Employed Vs Return On Invested Capital Vs Return On Equity
ROCE, return on invested capital, and return on equity are similar terms and might confuse people starting up with finance. However, there is a difference between these three. Let us check them out:
- ROCE is the term that assesses a company’s return based on the capital it puts to use.
- Return on invested capital refers to the ratio that helps assess the ability of a company to allocate appropriate capital to profitable investments.
- Return on equity is the ratio that helps determine a business’s profitability with respect to the shareholder’s equity.
The higher the ROCE, the better it is. The ratio calculated as 20% is considered good, indicating the company is more profitable and has a stable financial position in the market. However, for the calculation and comparison to be effective, one must consider companies from the same industry. If the companies from different sectors are taken for comparison, the results are not reflective of the real scenario.
The ROCE shows how profitable a company is with respect to the capital it employs to achieve the same. While comparing the two ROCEs, one must ensure the companies in consideration belong to the same industry.
The ROCE can be improved by reducing the costs incurred. First, the companies can cut costs where they think it is excessive or inefficient. This increases their operational efficiency. Secondly, the firms can increase sales by implementing various sales strategies. Finally, repaying debt and reducing liabilities of different forms also help improve the ROCE.
This has been a guide to what is Return on Capital Employed (ROCE). We explain its formula, differences with return on invested capital & return on equity. You can learn more about financing from the following articles –
- Asset Turnover RatioAsset Turnover RatioThe asset turnover ratio is the ratio of a company's net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet.
- Defensive Interval RatioDefensive Interval RatioThe defensive interval ratio evaluates the number of days a company can function without utilizing its non-current assets or outside financial resources. The formula is "Defensive Interval Ratio (DIR) = Current Assets / Average Daily Expenditures."
- Interest Coverage RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.
- Loan to Value RatioLoan To Value RatioThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value.