Return on Capital Employed: ROCE Meaning & Calculation

Return on Capital Employed (ROCE) is a crucial financial metric that indicates how efficiently a company utilizes its capital to generate returns. This metric is significant because capital is a crucial element for running any business, whether large or small. This capital typically comes from the equity and debt that a company raises. However, there are instances where a company may raise more capital than it effectively utilizes. That’s why ROCE is a key factor when evaluating an investment opportunity.

In this article, you'll learn about ROCE's meaning, how it's calculated using a formula, and what a good ROCE number is for proper interpretation

What is ROCE in Stock Market

Return on Capital Employed, also referred to as the ROCE, is a profitability metric that measures the efficiency with which the company uses its capital to generate profits. In simple words, this metric measures whether the company has used its money properly to generate good profits.

The financial metric is determined by using the company's EBIT against its total capital to assess its operational efficiency. Let us now break down the ROCE formula to understand its applications

How to Calculate Return on Capital Employed

Here is the ROCE formula and an example to help you calculate Return on Capital Employed in a step-by-step manner: 

ROCE Formula

ROCE is calculated by dividing EBIT (Earnings Before Interest and Tax) by Capital Employed and then multiplying the result by 100

ROCE = (EBIT/Capital Employed)*100

Here:

EBIT = Earnings Before Interest and Taxes

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

EBIT is used instead of net profit to calculate this metric because it indicates the company's fundamental operating profitability prior to considering financing costs (interest) and taxes.

ROCE Example

Let us consider two companies with different financial figures and see what numbers we arrive at for each of them:

Step 1: Calculate EBIT

While this metric is readily available on the income statement of the company, you should also be able to manually calculate the company’s EBIT.

You can calculate EBIT by subtracting operating expenses from total revenue, or by adding interest and taxes back to net profit. Here, the operating expenses typically include cost of goods sold (COGS), selling, general, and administrative expenses (SG&A), depreciation, and amortization.

Step 2: Calculate Capital Employed

Capital Employed  = Total Assets - Current Liabilities

Company A:

Capital Employed = 2000000 - 750000

Capital Employed = 1250000

Company B:

Capital Employed = 3500000 - 900000

Capital Employed = 2600000

Step 3: Calculate Return on Capital Employed

ROCE = (EBIT/Capital Employed)*100

Company A:

ROCE = (300000/1250000)*100

ROCE = 24%

Company B:

ROCE = (400000/2600000)*100

ROCE = 15.38%

Here, company A has generated an ROCE of 24% while company B has generated an ROCE of 15.38%. This means that Company A has used its capital more efficiently than Company B to generate earnings before interest and taxes.

What Is a Good ROCE?

While the metric can vary based on industries, a ROCE above 20% can be considered good for most Industries. This suggests that the company is efficiently using its capital to run its overall business. 

However, this benchmark doesn't apply universally. Industries that are not capital-intensive (like software or services) may naturally have higher ROCE, while capital-heavy sectors (like manufacturing, infrastructure, or utilities) tend to have lower ROCE due to the large investments required to operate.

Therefore, rather than keeping a benchmark for ROCE, it is better to compare the metrics within the respective industries. This will help you get a clearer picture of the companies and their profitability when compared to their peers.

Significance of ROCE in Financial Analysis

Here are a few points that tell you the significance of ROCE for companies and investors:

• Checking the capital efficiency 

ROCE compares the company’s profits with the total capital the company has in the business. This helps the investors determine if the particular company is using its resources wisely.

• Serves as a Benchmark for comparison 

Another use of ROCE is assessing the performance of two companies within the same industry. It can help you compare the capital efficiency of two or more companies and help you interpret their financial health, and also help to identify investment opportunities.

• Evaluating One's Own Finances

While ROCE is used among investors to compare companies and make investment decisions, it can also be used by businesses to determine the areas of their strength and areas where they need improvement. This insight can help improve their overall operations and profitability.

Limitations of Return on Capital Employed (ROCE)

Here are a few limitations of ROCE that one should be aware of before using this ratio for evaluating companies:

• Not a Standalone Indicator

While it reflects how efficiently the company has used its capital, it does not give a complete picture of the company. This metric should always be used in conjunction with other indicators to get a complete picture of the company.

• Relevant to the same Industry

ROCE is a very effective tool when comparing companies within the same industry. However, the capital requirements and profits earned by the companies vary based on industries. Thus, the metric loses its relevance if compared across different industries.

• Impact of Large Reserves

Many companies retain the profits earned, which become a part of the equity of the company. While these reserves are not immediately deployed in business operations, they have been set aside for future investments, contingencies, or strategic purposes. This leads to an artificially low ROCE. Therefore, one should also check the purpose of these reserves before drawing a conclusion on the lower ROCE figures.

ROCE vs ROE

Here is the difference between ROCE and ROE based on what they measure, their formulas, and their significance:

Conclusion

Return on Capital Employed (ROCE) is an important financial metric that helps assess how effectively a company is using its total capital to generate profits. This metric provides crucial insight into the companies operating within the same industry. However, like many financial metrics, ROCE also isn't perfect. Factors such as large reserves or varying capital structures across industries can impact its interpretation. Thus, it is also recommended to use this metric in conjunction with other financial indicators to get a holistic view of the company.

FAQs

Q1. What Is a Good ROCE?

A ROCE of 20% or higher is generally considered strong, though the ideal ROE can vary significantly across industries. For a more accurate assessment, it’s best to compare these metrics against industry averages rather than relying on fixed benchmarks.

Q2. Can ROCE be negative?

Yes, ROCE can be negative if a company reports a negative EBIT. This usually signals poor financial performance or significant losses and should serve as a warning sign for investors.

Q3. What is the difference between ROCE and ROE?

ROCE measures how efficiently a company generates returns from all capital employed, including both equity and debt. It provides a broader view of overall financial performance. ROE, on the other hand, focuses only on the returns generated from shareholders’ equity, making it more relevant for assessing equity investor returns.

Q4. How can investors use ROCE in stock analysis?

Investors use ROCE to evaluate how effectively a company generates profits from its total capital base, including both equity and debt. It helps compare capital efficiency across companies within the same industry and indicates how well management is utilizing all available resources to drive growth.