Return on Capital Employed (ROCE): Full Form, Formula, Ratio, Calculation Example

Return on Capital Employed (ROCE) is a way to measure that how well a company is using its money to make a profit in business. It clearly shows if the company is good at turning the money which invests into making more money.

People who are looking to invest in the company, like fund managers or investors pr other market participants, use this ratio to help them decide if it’s a smart investment or not. Basically, it helps answer the question "Is the company making good use of the money which it has?" Let’s understand deeper about ROCE and its formulae along with calculation, significance and limitations.

What is meant by Return on Capital Employed?

ROCE stands for Return on Capital Employed, it shows how efficiently an organization generates profit and measures its profitability after factoring in the capital used to achieve that profitability. It is likely an indicator that calculates the profitability ratio, which determines how efficiently an organization uses its capital to generate profits over time. 

ROCE is considered one of several profitability ratios investors use when analysing an organization for investment purposes. It includes equity and debt capital but does not evaluate short-term debt.

ROCE calculation formula

Investors check a company’s ROCE to determine whether they should invest in its shares or not. A higher ROCE shows that the company generates higher returns for every rupee of capital employed. ROCE is calculated on the below basis.

Let’s understand by assuming ROCE (Return on Capital Employed) with a simple example using two companies, Company A and Company B

ROCE = (EBIT/Capital Employed) *100

Where:

EBIT = Earnings Before Interest and Taxes

Capital Employed = Total assets - Current liabilities (Equity + Debt)

Let's assume the following financial data for Company A and Company B:

Understanding ROCE Calculation:

1. Calculate Capital Employed

• Company A : Capital Employed = Total Assets - Current Liabilities

= 3,000,000 - 1,000,000

= 2,000,000

• Company B : Capital Employed = Total Assets - Current Liabilities

= 4,500,000 - 1,200,000

= 3,300,000

2. Calculate ROCE

• Company A : ROCE = (EBIT / Capital Employed) × 100

= (500,000 / 2,000,000) × 100

= 25%

• Company B : ROCE = (EBIT / Capital Employed) × 100

= (700,000 / 3,300,000) × 100

= 21.21%

• Company A's ROCE is 25%.
• Company B's ROCE is 21.21%.

This calculation indicates that Company A is generating a higher return on its capital employed compared to Company B. While both companies are profitable, Company A is using its capital more efficiently to generate earnings before interest and taxes.

What is the best ROCE for a company to consider?

As per the industry standard’s there is no such particular number, a higher return on capital employed states that more efficiently that company working, generally we may consider above “20%” as a good number with considering an constant growth. 

However, the lower value may also be indicative of a company which is having a lot of cash on hand hence the cash component has been included in total assets. In some times the companies can perform better with lower ROCE.

Business cycles related to Economy and ROCE

ROCE is a financial ratio which shows how well a company uses its money to make run business and making profit with it, can change depending upon where the economy is at.

Here's how it works through different phases of the economy:

1. Expansion Stage (Good Times): When the economy is growing and people are having high purchase power, companies usually make more money. Because of this, their ROCE goes up they’re using their money better and making more profits.
2. Peak stage (Best of Times): At this point, growth starts to slow down, and there’s more competition. Even though companies are still making money, they might not be growing as fast as before. This can cause their ROCE to stay the same or drop a little because it’s harder to keep things running at their best.
3. Contraction stage (Tough Times): When the economy is struggling, companies often face less demand and lower sales. This can hurt profits and cause ROCE to go down, because businesses are having a hard time making their money work efficiently.
4. Recovery stage (Bouncing Back): As the economy starts to improve, companies see a slow increase in sales and profits. If they manage their costs well and adjust to the changes, their ROCE can start skyrocketing.
5. Early Growth stage (New Beginnings): In the early days of recovery, businesses may see a chance for growth and new investments. While this can cause their ROCE to go up or down depending on how well things go, it might start lower because they’re spending more money to grow. But if those investments work out, ROCE can improve over the time.

What is the significance of ROCE?

A higher ROCE indicates better performance in terms of using capital to generate profits.

When comparing companies, it’s crucial to look at ROCE to determine how efficiently a company is utilizing its capital.

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. 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. As ROCE may change every year, you will have to consider this metric over several years to compare the performance of companies accurately.