Return on Capital Employed (ROCE)

Return on capital employed (ROCE) is a financial statistic that may be used to analyze the profitability and capital efficiency of a firm.

In other words, this ROCE ratio can assist in determining how successfully a firm generates profits from its capital when it is used. When evaluating a firm for investment, financial managers, stakeholders, and potential investors may utilize the ROCE ratio as one of the numerous profitability ratios.

What is ROCE?

ROCE meaning: ROCE is a financial ratio used for assessing the profitability as well as the capital efficiency of a company. It helps to know how a company is performing and is raising its profits from its capital.

This financial metric is often used by investors to analyze before making an investment.

How to Calculate ROCE - ROCE Formula

Here is the Return on Capital Employed Formula:

EBIT = Earning Before Interest and Tax

Capital Employed = Total Assets – Current Liabilities

ROCE is a measure for assessing profitability and possibly comparing capital profitability levels across firms. Return on capital employed is calculated using two components: earnings before interest and tax and capital employed.

• EBIT: It is also known as operating income and indicates how much a firm generates from its operations alone, excluding interest and taxes. EBIT is determined by deducting revenue from the cost of goods sold and operating expenditures.
  
  
• Capital Employed: It is quite similar to the invested capital utilized in the ROIC calculation.
  
  Capital employed is calculated by deducting current obligations from total assets, yielding shareholders’ equity plus long-term loans. Instead of utilizing capital used at an arbitrary moment in time, some analysts and investors may prefer to compute ROCE using the average capital employed, which is the average of opening and closing capital utilized for the time period under consideration.

Examples of the Capital Employed Formula

Understand the application of ROCE Formula through the below given examples-

• Example 1

According to the most recent annual report, the firm generated a net operating profit of ₹20 million in 2018, with total assets and total current liabilities of ₹150 million and ₹90 million, respectively, as of the balance sheet date. Based on the facts provided, compute the company’s ROCE for the year.

Solution – 

The ROCE formula is given below.

Return on Capital Employed = EBIT / (Total Assets – Total Current Liabilities)

ROCE = ₹20 million / (₹150 million – ₹90 million)

ROCE is equal to 33.33% for 2018

• Example 2

According to the annual report, the company’s operating income in 2018 was ₹70.90 billion, with total assets and total current liabilities of ₹365.73 billion and ₹116.87 billion, respectively, as of September 29, 2018. Based on the information provided, compute the company’s ROCE for 2018.

Solution – 

ROCE Formula: Return on Capital Employed = EBIT / (Total Assets – Total Current Liabilities)

ROCE = ₹70.90 billion / (₹365.73 billion – ₹116.87 billion)

ROCE is equal to 28.49% for 2018

Importance of ROCE

• Return on Investment Employed is a measure of a company’s profitability that is based on how effectively it uses its capital in its business activities. ROCE is an essential statistic for an investor to use when making an investment choice based on a company’s ability to generate returns.
  
  
• Before making an investment choice, investors may use the ROCE ratio to compare different firms in the market. As an investor, you may utilize ROCE to determine which firm spends its money most effectively to create healthy returns.
  
  
• ROCE is extremely beneficial for comparing capital-intensive firms that demand a greater quantity of heavy capital in their operations. Automobile manufacturers, airlines, trains, steel producers, and so on are examples of such businesses. Because these firms have made significant investments in their capital, smart utilization of this money might prove to be a profitable investment option for any potential investor.
  
  
• ROCE is a helpful measure of financial efficiency since it calculates profitability after deducting the amount of capital needed to achieve that level of profitability.
  
  
• ROCE is beneficial for comparing firms in the same sector.
  
  
• ROCE is a valuable measure not just for investors but also for businesses, as it helps them assess their performance and identify their strengths and shortcomings, allowing room for performance development.

Limitations of Return on Capital Employed (ROCE)

Despite its various applications, the Return on Capital Employed (ROCE) ratio, like most other accounting measures, has certain limits.

• One of ROCE’s key drawbacks is that, while it is extremely beneficial when comparing the financial performances of two firms in the same sector, it does not offer precise data when comparing organizations in different industries.
  
  
• Using ROCE as a single metric of performance is ineffective since it only provides information on the company’s capital usage. As a result, it is always preferable to combine the ROCE ratio with other financial measures in order to make more educated investment decisions.
  
  
• Companies with underutilized cash reserves will have a reduced ROCE, which might have an influence on the actual result and the overall choice. ROCE is not the appropriate metric for businesses with sizable, untapped cash reserves.
  
  
• ROCE cannot remain constant over time and will change from year to year based on the company’s annual market performance. As a result, when comparing various firms, it is critical to evaluate ROCE changes across time.