There are many different formulas for measuring the profitability of a company, but lots of investors favour return on capital employed (ROCE), a profitability ratio that can be a great tool for identifying companies that are able to get a high return out of the capital they put into their business. What is ROCE and what are the advantages and disadvantages of return on capital employed? Find out everything you need to know with our comprehensive guide.
What is ROCE?
Return on capital employed – sometimes referred to as the ‘primary ratio’ – is a financial ratio that is used to measure the profitability of a company and the efficiency with which it uses its capital. Put simply, it measures how good a business is at generating profits from capital.
Advantages and disadvantages of return on capital employed
ROCE is a good way of comparing the performance of companies that are in capital-intensive sectors, such as the telecom industry. This is because it analyses debt and other liabilities as well as profitability, which provides a much clearer understanding of financial performance. Long-term ROCE is considered by many investors to be an important indicator of a business’s performance, and in most cases, a stable, rising ROCE is much more preferable to a volatile ROCE that changes drastically year upon year.
However, ROCE isn’t infallible. Because it’s based on the balance sheet and only looks at short-term achievements, it may not provide an accurate picture of a company’s future profitability. In addition, ROCE doesn’t consider the risk factors of different investments, which could lead to an inaccurate assessment of an investment’s long-term viability.
Return on capital employed formula
To calculate ROCE, you’ll need two key pieces of information: earnings before interest and tax (EBIT) and capital employed. EBIT is a calculation of revenue minus expenses (like interest and tax). The formula for working out EBIT is as follows:
EBIT = Revenue – COGS (Cost of goods sold) – Operating expenses
So, what about capital employed? Capital employed is the total amount of capital that businesses use to generate profits. There are two different formulas you can use to calculate capital employed:
Capital employed = Total Assets – Current Liabilities
Capital employed = Equity + Non-current Liabilities
So, what is the formula for return on capital employed? Once you know your figures for EBIT and capital employed, it’s relatively straightforward. The return on capital employed formula is as follows:
ROCE = EBIT / Capital Employed
Return on capital employed calculation example
To understand how ROCE works, let’s look at a quick return on capital employed calculation example. Let’s say a group of investors are trying to decide upon which company to invest in. Company 1 makes a profit of £1,000 on sales of $5,000 with £4,000 capital employed, giving them a ROCE of 25%. Company 2 makes a profit of £1,200 on sales of £5,000 with £6,000 capital employed, giving them a ROCE of 20%. Although in terms of pure profitability, Company 2 compares favourably with Company 1, by comparing the ROCE, you can see that in the long-term, Company 1 is likely to be more profitable.
What is a good return on capital employed?
The higher your ROCE is, the better. This is because a higher ROCE indicates that a higher percentage of your company’s value may be returned to stakeholders as profit. So, what is a good return on capital employed? Although a “good ROCE” varies depending on the size of your company, in general, the ROCE should be double the current interest rates at the very least.
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