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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) = 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.
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%.
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.