Return on Capital Employed (ROCE)

Updated on: Jul 18th, 2022 - 5:46:56 AM

6 min read

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What is Return on Capital Employed?

Return on Capital Employed or ROCE shows how efficiently a firm generates profit from the capital utilised. It is a profitability ratio that determines how efficiently a company uses its capital to generate profits. ROCE includes equity and debt capital but does not evaluate short-term debt. 

Investors check a company’s ROCE to determine if they should invest in its shares. A higher ROCE shows that the company generates higher returns for every rupee of capital employed. 

Return on Capital Employed (ROCE) Formula:

Return on Capital Employed (ROCE) = EBIT / Capital Employed

Earnings Before Interest and Tax or EBIT is a company’s profit that includes all expenses minus interest and tax expenses. It shows the company’s total income before cost deductions, and you can find it on the company’s Profit and Loss statement. 

Capital Employed is defined as a company’s total assets minus current liabilities or the sum of the fixed assets and working capital. It shows the net amount of equity invested in a company. In other words, capital employed is also defined as a company’s total equity plus total debt. 

How to calculate Return on Capital Employed (ROCE)?

Let’s understand ROCE calculations through an example. Suppose Company ABC Ltd. has EBIT of Rs 300 Crore in a financial year. On the other hand, Company XYZ Ltd has an EBIT of Rs 250 crore in the same financial year. 

Company ABC Ltd. seems a better investment as it has a higher EBIT than Company XYZ Ltd. However, it would be best to look at ROCE to determine which company is a better investment. Suppose the capital employed by Company ABC Ltd. is Rs 900 Crore and that of Company XYZ Ltd. is Rs 700 Crore. 

ROCE (Company ABC Ltd) = 300 / 900 = 0.333.

ROCE (Company XYZ Ltd) = 250 / 700 = 0.357.

It shows that Company XYZ Ltd. is a better investment than Company ABC Ltd. as it has a higher ROCE despite a lower EBIT. 

Let’s understand ROCE with another example. Suppose company DEF Ltd. has an equity capital of Rs 500 crore and a debt capital of Rs 300 crore. It generates an EBIT of Rs 150 Crore. 

ROCE = EBIT / Capital Employed (Total Equity + Total Debt).

ROCE = 150 / 800 = 0.1825 or 18.25%. 

What is the significance of ROCE?

  • ROCE helps you determine the performance of capital-intensive businesses such as petroleum refineries, car and steel manufacturers, etc. As these companies have massive investments, it is vital to gauge ROCE to determine investment opportunities.
  • As ROCE considers debt and other liabilities, it is better to determine a company’s profitability than the return on equity. For instance, a huge portion of capital is financed through debt in capital-intensive industries. As huge debt may artificially enhance ROE, it’s not an efficient measure of profitability than ROCE.
  • ROCE is used to compare the performance of companies in the same industry. Investors prefer firms with consistently rising ROCE to companies where it fluctuates.
  • Higher ROCE indicates better performance of a company than peers and rivals.
  • However, consider return on equity, return on assets and other performance measures along with ROCE when determining a company’s performance.

What are the limitations of ROCE?

  • ROCE does not offer accurate results when comparing the performance of companies in different sectors. 
  • Businesses with unused cash reserves have a lower ROCE. Hence, ROCE isn’t the best metric to gauge the performance of companies with substantial unused cash balances. 
  • ROCE measures return compared to the Book Value of Assets. However, as assets depreciate with time, ROCE increases even if cash flows are constant. Hence, older businesses whose assets have depreciated will have a higher ROCE than new companies, even though these firms may be better performers. 
  • As ROCE may change every year, you will have to consider this metric over several years to compare the performance of companies accurately. 

ROCE vs ROE: Which is Better?

Return on Equity is determined by dividing Net Income by Shareholders Equity. You can use it to measure any company’s performance except those that don’t make profits. 

However, ROCE is a better measure than ROE as it focuses on debt and equity. Hence, you may use ROCE to analyse the performance of companies that use debt as part of their capital structure. 

However, ROCE isn’t an effective measure to analyse the performance of finance companies as their business is based on leverage (debt). You may consider using Return on Assets (ROA) to measure the performance of these companies. 

Conclusion:

  • Many investors prefer investing in companies with ROCE > 15% over the past five years. 
  • You may use ROCE to compare the performance of capital-intensive industries. 

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