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

Return on Capital Employed (ROCE) is a key financial metric that measures a company's efficiency in using its capital to generate profit. It helps investors and analysts assess how effectively a company is turning invested funds into earnings. Understanding ROCE is essential for making informed investment decisions. In this article, we'll explore the formula, calculation, significance, and limitations of ROCE.

What is Return on Capital Employed?

ROCE stands for Return on Capital Employed, which shows how efficiently an organisation 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 organisation uses its capital to generate profits over time.

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

ROCE calculation formula

Investors examine a company’s ROCE to determine whether they should invest in its shares. A higher ROCE shows that the company generates higher returns for every rupee of capital employed. ROCE is calculated based on the following formula.

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?

According to industry standards, there is no specific number; a higher return on capital employed indicates that the company is operating effectively. Generally, we may consider the above “20%” as a good number, considering constant growth. 

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

Business cycles related to the Economy and ROCE

ROCE is a financial ratio that indicates how effectively a company utilises its capital to operate its business and generate a profit. It can change depending on the state of the economy.

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

1. Expansion Stage (Good Times): When the economy is growing and people have high purchasing power, companies typically generate more revenue. As a result, their ROCE increases, they’re using their money more effectively, and they generate more profits.
2. Peak stage (Best of Times): At this point, growth starts to slow down, and there’s more competition. Although companies are still generating profits, they may not be growing as quickly as they were in the past. This can cause their ROCE to remain the same or drop slightly because it’s harder to maintain optimal performance.
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 begins to improve, companies experience a gradual increase in sales and profits. If they manage their costs effectively and adapt to changes, their ROCE can start to increase significantly.
5. Early Growth Stage (New Beginnings): In the early days of recovery, businesses may see opportunities for growth and new investments. While this can cause their ROCE to fluctuate depending on how well things go, it may start lower because they’re spending more money to grow. However, if those investments are successful, ROCE can improve over time.

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 utilising 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.

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 fluctuate from year to year, it is essential to consider this metric over several years to compare the performance of companies accurately.

Conclusion

ROCE can offer valuable insights into a company's performance, however, its limitations, such as sector differences, cash reserves, and yearly fluctuations, necessitate a cautious and thorough approach. Using ROCE alone may not give an accurate picture, so it's best to combine it with other metrics for more reliable comparisons.