Return on capital employed (ROCE) is a profitability ratio. It is a financial measure that enables a company to determine how much profit it has earned against the capital it has put to use. It’s one of the many profitability ratios used by stakeholders, financial managers, and potential investors to analyse a company’s performance before investing.
Return on capital employed is particularly important when comparing the performance of different companies in capital-intensive sectors. The calculation of ROCE will give you the amount of profit a company is generating against every Rs 1 of capital employed. The higher the profit a company generates per Rs 1, the better. Thus, higher a company’s ROCE ratio, the more profit it generates.
Importance of ROCE
ROCE is a measure of a company’s financial performance and efficiency. Unlike other profitability and financial measures, such as return on equity (ROE), which measures the profitability of a company in relation to its shareholder’s equity, ROCE considers both equity and debt. Investors and analysts use ROCE and ROE to get a more accurate picture of the financial performance of a company.
ROCE is a widely used metric by investors and analysts when assessing a company’s potential as an investment. It helps evaluate a company’s efficiency in utilising its capital and financial strategies.
A company’s ROCE should ideally be higher than the interest rate on any loans or borrowings used to finance its assets. A lower ROCE suggests the company is not performing well and may not be able to generate returns for itself or its investors.
- It helps investors make sound financial decisions.
- It determines the value of financial returns on equity and debt.
- It enables investors to compare the financial performance of different companies from the same sector with similar amounts of working capital.
You can use the formula given below to calculate ROCE.
ROCE = Earnings before interest and taxes (EBIT) / Capital Employed
EBIT is also referred to as operating income. It is the total revenue of a company minus the cost of goods sold and operating expenses. It is an indication of how much profit a company earns from its operations after deducting interests and taxes.
Capital employed is the total assets minus current liabilities.
Suppose a company generated a net profit of Rs 20 million, with total assets and current liabilities amounting to Rs 150 million and Rs 90 million, respectively.
ROCE of the company = EBIT / (Total assets – Total current liabilities)
ROCE = Rs 20 million (Rs 150 million – Rs 90 million) = 33.33%
Factors that can affect ROCE
Since ROCE is a measure of a company’s profitability, factors that impact profitability also impact ROCE. A company can improve its ROCE through the same process it employs to increase its profitability. Some factors that affect a company’s ROCE include costs, sales, debts, inventory, and working capital.
The ROCE of a company improves when costs reduce and sales increase. When a company pays off its debts and reduces its liabilities, it can improve its profitability and ROCE. Additionally, a company can refinance at lower interest rates and restructure its existing debts to improve the ROCE ratio.
Lastly, inventory management is one of the most crucial factors in improving a company’s financial performance. Effective inventory management can significantly improve the cash flow and the availability of the working capital of a company. It enables the company to regularly reinvest more capital back into different processes, ensuring growth and profitability.
Limitations of using ROCE as a performance metric
Despite its several uses, ROCE comes with some limitations.
- ROCE is not enough to compare the financial performance of two companies in different sectors.
- ROCE is mostly ineffective on its own since it gives value to a company’s performance only based on the capital employed. Thus, using ROCE with other financial ratios is a more holistic approach.
- ROCE is also not an effective measure for companies with huge reserves of unused cash
- ROCE fluctuates from one year to another. Thus, investors have to analyse trends from several years while comparing different companies.
ROCE is a measure of a company’s profitability that compares its operating income to the capital employed in its business. It is generally considered a good indicator of a company’s financial performance, as it measures the efficiency with which it uses its capital. However, it is essential to note that ROCE should be used in conjunction with other financial metrics, such as revenue growth, asset turnover, and net profit margin, to gain a complete understanding of a company’s financial performance.