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.

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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

• EBIT (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.read more) – It can be calculated by adding taxes and interest back into net profit.
• Capital employed (Total Assets – Current Liabilities) – 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."read more can be referred to as the total assets of a firm after accounting for all the short term or 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.read more. 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 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 Equityread more and current liabilities give us the right figure of 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 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 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 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 [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 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.

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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more 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 31^st 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 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 –

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 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).

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.

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.

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 (ROICROICReturn on Invested Capital (ROIC) is a profitability ratio that shows how a company uses its invested capital, such as equity and debt, to generate profit. The reason this ratio is so crucial for investors before making an investment is that it helps them decide which firm to invest in.read more), Return on Asset (ROAROAReturn on assets (ROA) is the ratio between net income, representing the amount of financial and operational income a company has, and total average assets. The arithmetic average of total assets a company holds analyses how much returns a company is producing on the total investment made.read more), Interpret ROEInterpret ROEReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more, etc.

ROCE Video

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