What is the return on capital employed (ROCE) formula and why is it useful?

Revolut Contributor

 · July 06, 2020  · 07/06/2020

The return on capital employed (ROCE) is a ratio which indicates how efficiently a business uses its capital to generate profits. This is a crucial metric to track in management accounts, and investors often rely on it to help them assess which businesses to fund. You need to know what ROCE means and how to calculate it. The good news is we're about to do so…

What does the ROCE ratio tell us?

Profitability ratios reveal insights about the financial health of a business relative to a specific variable – in this case, capital employed – over a given period. ROCE falls into the category of return ratio because it uses elements in the balance sheet as well as the income statement of a business, to calculate how effectively it creates a return for the shareholders.

The ROCE is regarded as a reliable indicator of financial performance. Ignore it at your peril.

How do I calculate return on capital employed?

The ROCE formula is simple. You merely divide the operating profit of the business for a given period by the capital employed within it during the same timeframe. You then multiply the result by one hundred to express the basic ratio as a percentage.

Return on capital employed ratio = (Operating profit / Capital employed) x100

In most scenarios, the operating profit figure is the same as EBIT (i.e. Earnings Before Tax and Interest). These two terms are often considered to be synonyms, despite nuances. Occasionally, the net profit is used instead of either, which makes a big difference to the result as this deducts interest on loans and tax owed.

The capital employed is the sum of the main elements on the balance sheet: share capital, retained earnings and long-term debt. Another way to express capital employed is to take the total assets of the business and deduct current liabilities. Because the amount of capital employed fluctuates, it's common to calculate ROCE with the average for the same period.

What does a high return on capital employed mean?

A higher ROCE percentage reveals that a business is successful at converting its capital into operating profit, and this invariably means happy investors. If the ROCE falls below the rate at which the capital itself is sourced (i.e. the cost) difficult conversations probably lie ahead.

There are two ways to boost ROCE: increase the level of the operating profit or reduce the capital employed. The wriggle-room here is that legitimate adjustments are often needed to make the ROCE more realistic. For instance, a business might hold cash that it does not use for day-to-day operations. If so, it should rightly deduct this sum from the amount of capital employed and that will result in a higher ROCE ratio. Given that it's common to calculate the ROCE with slightly different methods, it's wise to check these type of points.

What is a good return on capital employed percentage?

ROCE is a great way to compare businesses in capital intensive sectors like engineering as, unlike other profit metrics, it takes debt and other liabilities into account. As with all financial ratios, it's more insightful to track ROCE against the same metric from earlier periods, a forecast, or an industry benchmark than to define one arbitrary value as a 'good' result.

People typically use ROCE alongside two other return ratios – namely, the return on equity (ROE) and return on assets (RoA) – to provide a broader picture of performance. Consistency matters too. Investors tend to favour a business with a stable or rising ROCE over one where this vital ratio pings around from year to year. A volatile ROCE is rarely a positive sign as it creates uncertainty around future returns and this can spook investors.

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