Return on Capital Employed (ROCE) is a financial ratio that measures a company’s profitability and efficiency in using its capital. It indicates how well a company is generating profits from its capital, including both equity and debt. Essentially, it shows how effectively management is utilising the capital invested in the business to generate its earnings. Below is the formula to calculate ROCE:
ROCE = EBIT \ Capital Employed
EBIT stands for Earnings before Interest and Taxes. Capital Employed refers to the total capital invested in the business, which can be calculated as below:
Capital Employed = Total Assets – Current Liabilities
or
Capital Employed = Equity + Non-current Liabilities
Seems complicated? Below is an example.
Company: ATAPT Industries has Earnings Before Interest and Taxes of £500,000, Total Assets of £2,000,000, and Current Liabilities of £600,000.
Step 1: Calculate Capital Employed
Capital Employed can be calculated as:
Capital Employed = Total Assets − Current Liabilities
Capital Employed = £2,000,000 − £600,000 = £1,400,000
Step 2: Calculate ROCE
Now that we have both EBIT (£500,000) and Capital Employed (£1,400,000), let’s calculate the ROCE at ATAPT Industries:
ROCE = EBIT / Capital Employed × 100
ROCE = £500,000 / £1,400,000 × 100 = 35.71%
OK, to summarise what an ROCE of 35.71% means – for every pound of capital employed, ATAPT Industries generates just shy of 36 pence of operating profit before interest and taxes.
ROCE should be used to compare companies within the same industry and preferably that of companies in capital-intensive sectors such as utilities, airlines or telecoms etc, this is because ROCE takes into consideration debt and equity, unlike Return on Equity ROE which focuses on profitability-related to a company’s shareholder equity.
ROCE shows how well a company generates returns relative to their capital base. In short, a higher ROCE suggests that a company is using its capital efficiently to generate its profits and should be used to compare businesses within the same sector.
Return on Capital Employed (ROCE) shouldn’t be relied upon on its own and should be used in conjunction with other ratios, perhaps something like the price-to-earnings (P/E) ratio.