Return on capital employed (ROCE): Definition and how to calculate
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Return on capital employed (ROCE) is a popular financial metric that helps investors, analysts and managers assess the overall profitability of a business. This ratio shows how efficiently a company is using its capital to generate profits, allowing one to compare companies.
Here’s how ROCE works, including how to calculate it, the ratio’s limitations and how ROCE compares to several other popular financial ratios.
Why ROCE matters
ROCE is the amount of profit a company generates for each dollar of capital employed in the business. The higher the profit generated per dollar or capital, the more efficient the company is at turning capital into profit. So a higher ROCE indicates higher efficiency when comparing companies.
ROCE proves particularly valuable when comparing the performance of companies operating in capital-intensive sectors such as utilities. ROCE takes into account the total amount of capital the company uses – both debt and equity – unlike metrics such as return on equity (ROE), which solely assess profitability in relation to shareholders’ equity. Therefore, the ROCE approach gives a fuller picture of the underlying efficiency of companies, especially those with substantial debt.
Return on capital employed (ROCE) is a measure of efficiency that considers both debt financing and shareholder equity. A company with a high return on equity (ROE) aided by a substantial debt load might look much different once looked at through the lens of ROCE that factors in the debt as well as the equity.— Greg McBride | Bankrate Chief Financial Analyst
ROCE can be used to track a company’s capital efficiency over time as well as in comparison with other firms, either in its own industry or across industries. Keep in mind, however, that a high ROCE in one industry might be considered low in another.
In addition to company comparisons, businesses can also use ROCE to evaluate in-house projects or individual business units.
How to calculate ROCE
ROCE is calculated by dividing the company’s earnings before interest and taxes (EBIT) by the capital employed. Capital employed can be calculated by adding shareholder’s equity and total debt, including both short-term and long-term debts.
The formula for ROCE is as follows:
ROCE = Earnings before interest and tax (EBIT) / Capital employed*
*Capital employed = Shareholder’s equity + total debt
A higher ROCE indicates more effective use of capital, while a lower ROCE can be a sign of poor company management or simply a bad business. When evaluating a company, consider other profitability ratios, such as return on equity and return on assets alongside ROCE to get a fuller picture of the company’s financial efficiency.
However, ROCE is generally not suitable for companies that rely heavily on leverage, such as banks, private equity and venture capital and real estate investing, to name a few. Companies that rely heavily on debt will have low ROCEs, and the figure will not encompass the potential returns or risks associated with the company.
What is a good ROCE?
Generally, an acceptable ROCE exceeds a company’s weighted average cost of capital (WACC). The WACC is a measure that factors in the costs of the company’s sources of capital such as equity and debt financing. If a company’s ROCE is not regularly above the weighted average cost of its capital, it’s wasting capital by continuing to operate. So a firm’s cost of capital acts as a hurdle rate for the business, a minimum level of profitability that should be achieved.
There isn’t a benchmark level for a good ROCE that applies to all industries and sectors, since some sectors have much better businesses than others. So what’s considered a good ROCE will vary depending on the industry. That said, investors tend to prefer companies with stable and rising ROCE over a period of time, indicating a better business or improved management.
How to improve ROCE
Companies have several options for improving their ROCE ratio. These options include strategies to increase profitability (return) or reduce capital employed in the business:
- Cutting costs, for example, through improvements in operational efficiency or product redesign.
- Boosting sales, which increases overall profitability.
- Reducing debt, by repaying the principal.
- Returning capital to shareholders, by repurchasing stock or paying a dividend.
These options focus on either side of the ROCE ratio – raising the numerator of returns or decreasing the denominator of capital employed.
The limitations of ROCE
While ROCE can be helpful to more fully analyze a company, it does have some drawbacks:
- Lack of external factors
- ROCE may not account for changes in the industry, economic conditions, or other external variables that can significantly impact a company’s performance. For instance, ROCE does not factor in inflation. So profits may rise with inflation, but the company may still own its old depreciated assets to produce those profits, meaning that ROCE ends up overstated.
- Sector comparability
- If you’re trying to compare companies in different industries, ROCE is likely not the best metric. Each industry has unique characteristics that affect its capital requirements and profitability, making it challenging to make meaningful comparisons using ROCE alone.
- Limited financial performance scope
- Factors like revenue growth, profit margins, cash flow generation and return on equity are not captured within the ROCE calculation.
- Historical perspective
- ROCE is a backward-looking metric, meaning it relies on past financial data, making it less reliable in reflecting current market conditions or growth possibilities.
- Vulnerable to manipulation
- Like any financial indicator, ROCE can be susceptible to manipulation through financial engineering or accounting techniques.
ROCE vs other financial metrics
Investors can use a number of financial ratios to evaluate a company. Here are some that are often used in conjunction with ROCE, or commonly confused with ROCE.
ROCE vs. ROE
ROCE and return on equity (ROE) both measure profitability in a company, but there are some key differences between the two metrics.
ROCE = Earnings before interest and tax (EBIT) / Capital employed*
ROE = Net income / Average shareholders’ equity
ROE measures a company’s after-tax profits as a percentage of its shareholder equity. It shows how efficient the business is at generating profit with shareholder funds. The formula for return on equity is after-tax profits divided by shareholder’s equity.
In contrast, ROCE considers all funding sources for capital both debt and equity financing. while ROE only focuses on shareholder equity. ROCE also focuses on earnings before interest and taxes, rather than after-tax profits.
ROE can be used to evaluate virtually any company, while ROCE should be restricted to analyzing non-finance companies.
ROCE vs. ROIC
While both ROCE and return on invested capital (ROIC) measure an aspect of a company’s profitability, there are some distinctions between the two.
ROIC measures the company’s after-tax profitability and compares it to how much capital is invested in the operational assets of the business, not just how much capital is on the balance sheet. Invested capital is a subset of capital employed and does not include assets such as cash and equivalents that are not needed to run the business. The formula for ROIC is after-tax profit divided by invested capital, where invested capital is shareholder’s equity plus any debt financing minus non-operating cash and investments.
ROIC = Net operating profit after tax / invested capital*
*Total debt and leases + total equity and equity equivalents – non-operating cash and investments
In contrast, ROCE is calculated using operating income generated prior to interest and tax payments. ROIC generally is a bit more complicated to calculate compared to ROCE as there are several ways to calculate invested capital.
ROCE vs. ROI
Although similar in name, ROCE and ROI are two different calculations.
Return on investment (ROI) is a measure of the total return on an investment regardless of its source of financing. The formula for ROI is the profit from the investment divided by the cost of the investment.
ROI = Profit from the investment / cost of the investment
ROCE is figured using earnings before interest and taxes divided by the company’s total capital, both equity and debt. While ROI can be used to compare products and investment opportunities, ROCE is more specific to companies.
Bottom line
Return on capital employed (ROCE) is a useful financial metric for evaluating a company, but like most financial ratios, it has some limitations. So you’ll want to consider ROCE in conjunction with other financial ratios such as ROIC and ROE to generate the fullest picture of the company.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
