Return on Capital Employed Definition
Return on Capital Employed (ROCE) is a measure which identifies the effectiveness in which the company uses its capital and implies the long term profitability and is calculated by dividing earnings before interest and tax (EBIT) to capital employed, capital employed is the total assets of the company minus all the liabilities.
Explanation
It is a profitability ratio that tells us how a company is using its capital and depicts the company’s ability to efficiently utilize its capital. It is very useful from the perspectives of investors because from this ratio they get to decide whether this company would be good enough to invest in.
For example, 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 into a concrete conclusion.
Return on Capital Employed of Home Depot has grown phenomenally and currently stands at 46.20%. What does this mean for the company and how it impacts the decision-making process of the investors? How should we view the return on capital employed?
Formula
Let’s have a look at the Return on Capital Employed formula to have an understanding of how to calculate the profitability –
ROCE Ratio = Net Operating Income (EBIT) / (Total Assets – Current Liabilities)
There are so many factors we need to take into account. First, there is net operating income or EBIT (Earnings before interest and tax). Let’s talk about it first.
If you have an income statement in front of you, you would see that after deducting the cost of goods sold and operating expenses. Here’s how you should calculate Net Operating Income vs EBIT –
| In US $ | |
| Revenue for the year | 3,300,000 |
| (-) COGS (Cost of Goods Sold) | (2,300,000) |
| Gross Revenue | 1,000,000 |
| (-) Direct Costs | (400,000) |
| Gross Margin (A) | 600,000 |
| Rent | 100,000 |
| (+) General & Administration Expenses | 250,000 |
| Total Expenses (B) | 350,000 |
| Operating Income before tax (EBIT) [(A) – (B)] | 250,000 |
So if you have been given the income statement, it would be easy for you to find out net operating income or EBIT from the data using the above example.
Also, have a look at EBIT vs EBITDA
Now let’s look at the total assets and what we would include in the total assets.
We will include everything that is capable of yielding value for the owner for more than one year. That means we will include all fixed assets. At the same time, we will also include assets that can easily be converted into cash. That means we would be able to take current assets under total assets. And we will also include intangible assets that have value but they are non-physical in nature, like goodwill. We will not take fictitious assets (e.g. promotional expenses of a business, discount allowed on the issue of shares, the loss incurred on issue of debentures, etc.) into account.
And as in the current liabilities, we will take into account the following.
Under current liabilities, the firms would include accounts payable, sales taxes payable, income taxes payable, interest payable, bank overdrafts, payroll taxes payable, customer deposits in advance, accrued expenses, short term loans, current maturities of long term debt, etc.
Now capital employed doesn’t only include shareholders’ funds; rather it also includes debt from the financial institutions or banks and debenture holders. And that’s why the difference between total assets and current liabilities will give us the right figure of capital employed.
Interpretation of ROCE
Return on capital employed is a great ratio to find out whether a company is truly profitable or not. If you compare between two or multiple companies there are few things you should keep in mind
- First, whether these companies are from similar industries. If they are from a similar industry, it makes sense to compare; otherwise, the comparison doesn’t create any value.
- Second, 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.
- Third, find out the average ROCE of the industry to make sense of what you find.
If you take these three things into consideration, you can calculate ROCE and can decide whether to invest in the company or not. If ROCE is more, that’s better because that means the company has utilized its capital well.
- There is one more thing you should think about. You can use Net Income to come up with the ratio as well to get a holistic picture. The actual ratio is – EBIT / Capital Employed, but you can experiment by putting Net Income (PAT) / Capital Employed to see whether there is any difference or not.
- Moreover, you shouldn’t decide whether to invest in a company purely after calculating only one ratio; because one ratio can’t depict the whole picture. calculate all the profitability ratios and then decide whether this company is truly profitable or not.
Return on Capital Employed Examples
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 A | Company B |
| EBIT | 30,000 | 40,000 |
| Total Assets | 300,000 | 400,000 |
| Current Liabilities | 15,000 | 20,000 |
| ROCE | ? | ? |
Also, look at this comprehensive Ratio Analysis 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 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 let’s calculate the ratio for both of these companies –
| In US $ | Company A | Company B |
| EBIT (X) | 30,000 | 40,000 |
| Capital Employed (Y) | 285,000 | 380,000 |
| 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 A | Company B |
| Revenue | 500,000 | 400,000 |
| COGS | 420,000 | 330,000 |
| Operating Expenses | 10,000 | 8,000 |
| Total Assets | 300,000 | 400,000 |
| Current Liabilities | 15,000 | 20,000 |
| ROCE | ? | ? |
Here we have all the data for computation of EBIT and Capital Employed. Let’s first calculate EBIT 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 A | Company B |
| Revenue | 500,000 | 400,000 |
| (-)COGS | (420,000) | (330,000) |
| Gross Revenue | 80,000 | 70,000 |
| (-)Operating Expenses | (10,000) | (8,000) |
| EBIT (Operating Profit) (M) | 70,000 | 62,000 |
Let’s now calculate the Capital Employed –
| In US $ | Company A | Company B |
| Total Assets | 300,000 | 400,000 |
| (-)Current Liabilities | (15,000) | (20,000) |
| Capital Employed (N) | 285,000 | 380,000 |
Let’s calculate Return on Capital Employed –
| In US $ | Company A | Company B |
| EBIT (Operating Profit) (M) | 70,000 | 62,000 |
| Capital Employed (N) | 285,000 | 380,000 |
| 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.
Nestle Example
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 the period of 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
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 | ||
| 2015 | 2014 | |
| Operating Profit (A) | 12408 | 14019 |
| Total assets | 123992 | 133450 |
| Total current liabilities | 33321 | 32895 |
We know the EBIT or the operating profit. We need to calculate the capital employed –
| In millions of CHF | ||
| 2015 | 2014 | |
| Total assets | 123992 | 133450 |
| (-)Total current liabilities | (33321) | (32895) |
| Capital Employed (B) | 90,671 | 100,555 |
Now, let’s calculate the ratio.
| In millions of CHF | ||
| 2015 | 2014 | |
| Operating Profit (A) | 12408 | 14019 |
| Capital Employed (B) | 90,671 | 100,555 |
| 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 investment is much higher than other industries, thus the ratio would be less than other industries.
Home Depot Example
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 –
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 Ratio = Net 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 increases either because of 1) increase in EBIT 2) decrease in Equity 3) 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 a 7 year period).
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
source: ycharts
If we look at Home Depot’s Shareholder’s Equity section, we find the possible reasons for such a decrease.
- Accumulated Other Comprehensive Loss has resulted in the lowering of shareholders’ equity in both 2015 and 2016.
- Accelerated Buybacks were the second and most important reason for the decrease in Shareholder’s equity in 2015 and 2016.
#3 – EVALUATING 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 $23.60 billion in 2016. This 143% increase in debt resulted in the lowering of the ROCE.
source: ycharts
Summary of Home Depot Analysis
We note that Home Depot ratio increased from ratio of ~ 15% in FY10 to 46.20% in FY17 because of the following –
- EBIT increased by 180% over the 7 year period (2010-2017). It significantly increases ratio due to an increase in the numerator
- Shareholder Equity decreased by 77% in the corresponding period. This significantly reduces the denominator thereby increasing the ROCE.
- Overall, an increase in ratio because of the two factors above (1 and 2) was offset by the 143% increase in debt during the corresponding period.
Sector Return on Capital Employed
Utilities – Diversified Example
| S. No | Name | Market Cap ($ mn) | ROCE |
| 1 | National Grid | 51,551 | 5.84% |
| 2 | Dominion Energy | 50,432 | 6.80% |
| 3 | Exelon | 48,111 | 2.16% |
| 4 | Sempra Energy | 28,841 | 6.08% |
| 5 | Public Service Enterprise | 22,421 | 4.76% |
| 6 | Entergy | 14,363 | -1.70% |
| 7 | FirstEnergy | 13,219 | -19.82% |
| 8 | Huaneng Power | 11,081 | 11.25% |
| 9 | Brookfield Infrastructure | 10,314 | 5.14% |
| 10 | AES | 7,869 | 5.19% |
| 11 | Black Hills | 3,797 | 4.54% |
| 12 | NorthWestern | 3,050 | 5.14% |
- Overall, the Utilities sector has a lower ROCE (in the range of 5%).
- Two companies in the group above have a negative ratio. Entergy has an RCOE of -1.70% and FirstEnergy has ratio of -19.82%
- The best company in this group is Huaneng Power with a ratio of 11.25%.
Beverages – Soft Drinks Example
| S. No | Name | Market Cap ($ mn) | ROCE |
| 1 | Coca-Cola | 193,590 | 14.33% |
| 2 | PepsiCo | 167,435 | 18.83% |
| 3 | Monster Beverage | 29,129 | 24.54% |
| 4 | Dr. Pepper Snapple Group | 17,143 | 17.85% |
| 5 | National Beverage | 4,156 | 45.17% |
| 6 | Embotelladora Andina | 3,840 | 16.38% |
| 7 | Cott | 1,972 | 2.48% |
- Overall, the Beverages – Soft Drinks sector has better ROCE as compared to the Utility sector with the average ratio at around 15-20%.
- We note that between PepsiCo and Coca-Cola, PepsiCo has a better ratio of 18.83% as compared to Coca-Cola’s ratio of 14.33%
- National Beverages has the highest ratio of 45.17% in the group
- Cott, on the other hand, has the lowest ratio of 2.48% in the group.
Global Banks Example
| S. No | Name | Market Cap ($ mn) | ROCE |
| 1 | JPMorgan Chase | 306,181 | 2.30% |
| 2 | Wells Fargo | 269,355 | 2.23% |
| 3 | Bank of America | 233,173 | 1.76% |
| 4 | Citigroup | 175,906 | 2.02% |
| 5 | HSBC Holdings | 176,434 | 0.85% |
| 6 | Banco Santander | 96,098 | 2.71% |
| 7 | The Toronto-Dominion Bank | 90,327 | 1.56% |
| 8 | Mitsubishi UFJ Financial | 87,563 | 0.68% |
| 9 | Westpac Banking | 77,362 | 3.41% |
| 10 | ING Group | 65,857 | 4.16% |
| 11 | UBS Group | 59,426 | 1.29% |
| 12 | Sumitomo Mitsui Financial | 53,934 | 1.19% |
- We note that the overall Banking Sector has one of the lowest ROCEs as compared to the other sectors with an average ratio of 1.5%-2.0%
- JPMorgan, the largest Market Cap Bank has a ratio of 2.30%
- ING has the highest ratio of 4.16% in the group, whereas, Mitsubishi UFJ Financial has the lowest ratio of 0.68%
Energy – E&P Example
| S. No | Name | Market Cap ($ mn) | ROCE |
| 1 | ConocoPhillips | 56,152 | -5.01% |
| 2 | EOG Resources | 50,245 | -4.85% |
| 3 | CNOOC | 48,880 | -0.22% |
| 4 | Occidental Petroleum | 45,416 | -1.99% |
| 5 | Canadian Natural | 33,711 | -1.21% |
| 6 | Pioneer Natural Resources | 26,878 | -5.26% |
| 7 | Anadarko Petroleum | 25,837 | -6.97% |
| 8 | Apache | 18,185 | -5.71% |
| 9 | Concho Resources | 17,303 | -18.24% |
| 10 | Devon Energy | 16,554 | -13.17% |
| 11 | Hess | 13,826 | -12.15% |
| 12 | Noble Energy | 12,822 | -6.89% |
- Overall, Energy Sector ROCE looks pretty bad with negative ratios with all top companies. This is primarily due to negative operating income resulting from a slowdown of commodities (crude oil)
- Concho Resources is the worst performing in this sector with a ratio of -18.24%
- ConocoPhillips with the market cap of $56 billion has a ratio of -5.01%
Internet and Content Example
| S. No | Name | Market Cap ($ mn) | ROCE |
| 1 | Alphabet | 664,203 | 17.41% |
| 2 | 434,147 | 22.87% | |
| 3 | Baidu | 61,234 | 12.28% |
| 4 | JD.com | 54,108 | -6.59% |
| 5 | Altaba | 50,382 | -1.38% |
| 6 | NetEase | 38,416 | 37.62% |
| 7 | Snap | 20,045 | -48.32% |
| 8 | 15,688 | 15.83% | |
| 9 | 12,300 | -5.58% | |
| 10 | VeriSign | 9,355 | 82.24% |
| 11 | Yandex | 8,340 | 12.17% |
| 12 | IAC/InterActive | 7,944 | 0.67% |
- Overall, this sector has a mixed ROCE with a very high and negative ratio
- Between Alphabet (Google) and Facebook, Facebook has a higher ratio of 22.87% as compared to the Alphabet’s ratio of 17.41%
- Snap (that came out with its recent IPO) has a ratio of -48.32%
- Other companies with negative ratio are Twitter (-5.58%), Altaba (-1.38%), JD.com (-6.59%)
- Verisign has the highest ratio of 82.24% is the group
Discount Stores Example
| S. No | Name | Market Cap ($ mn) | ROCE |
| 1 | Wal-Mart Stores | 237,874 | 17.14% |
| 2 | Costco Wholesale | 73,293 | 22.03% |
| 3 | Target | 30,598 | 18.98% |
| 4 | Dollar General | 19,229 | 22.54% |
| 5 | Dollar Tree Stores | 16,585 | 12.44% |
| 6 | Burlington Stores | 6,720 | 23.87% |
| 7 | Pricesmart | 2,686 | 19.83% |
| 8 | Ollie’s Bargain Outlet | 2,500 | 11.47% |
| 9 | Big Lots | 2,117 | 26.37% |
- Overall, the discount store sector enjoys a healthy ROCE (average closer to 20%)
- Wal-Mart Stores with a market cap of $237.8 billion has a ratio of 17.14%. Costco, on the other hand, has a ratio of 22.03%
- We note that Big Lots has the highest ratio of 26.37% in the group, whereas, Ollie’s Bargain Outlet has the lowest ratio of 11.47%
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 Margins, Return on Invested Capital (ROIC), Return on Asset (ROA), Interpret ROE, etc.
