Return on capital employed

What Is Return on Capital Employed?

Return on capital employed (ROCE) is a crucial profitability ratio that measures how efficiently a company uses its capital to generate profits. It is a key metric within financial analysis, providing insight into a company's ability to create value from the total capital it employs in its operations. ROCE helps investors and analysts understand how well a business is utilizing its capital structure to generate earnings before interest and taxes. A higher ROCE typically indicates more efficient capital utilization and stronger financial performance.

History and Origin

The concept of evaluating a business's efficiency in using its assets to generate profits has been fundamental to financial analysis for centuries. While a precise "invention date" for the specific Return on Capital Employed metric is not documented, its underlying principles emerged with the formalization of accounting practices and the development of modern financial ratios in the 19th and 20th centuries. As businesses grew in complexity and capital investment became more significant, the need to assess how effectively capital was being deployed became paramount for investors and management alike. The evolution of performance measurement tools, including ROCE, reflects the increasing sophistication of financial markets and the drive for greater transparency in corporate reporting.

Key Takeaways

Return on capital employed (ROCE) measures a company's ability to generate profits from its capital.
It is a key indicator of operational efficiency and capital allocation effectiveness.
A higher ROCE generally signifies that a company is using its capital more productively.
ROCE is particularly useful for comparing capital-intensive businesses within the same industry.
It provides insights into a company's potential for sustainable growth and competitive advantage.

Formula and Calculation

The formula for Return on Capital Employed (ROCE) is calculated as follows:

\text{ROCE} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Capital Employed}}

Where:

Earnings Before Interest and Taxes (EBIT), also known as operating profit, represents a company's profit from its core operations before deducting interest expenses and taxes. It is found on the income statement.
Capital Employed is the total capital used to generate the profit. It can be calculated in two main ways:
- Method 1 (Assets Minus Liabilities): Total assets minus current liabilities.
- Method 2 (Equity Plus Debt): Shareholders' equity plus long-term debt.
  Both methods should yield the same capital employed figure, representing the long-term funds tied up in the business.

Interpreting the Return on Capital Employed

Interpreting Return on Capital Employed involves assessing a company's operational efficiency and its ability to generate profits from the capital invested in its business. A higher ROCE indicates that the company is effectively utilizing its capital to produce a greater amount of earnings. For instance, a ROCE of 20% means that for every dollar of capital employed, the company generates 20 cents in earnings before interest and taxes.

When evaluating ROCE, it's crucial to compare it against a company's cost of capital. If a company's ROCE is consistently higher than its cost of capital, it suggests that the business is creating value for its shareholders. Conversely, if ROCE is lower than the cost of capital, the company may be destroying value, indicating inefficient asset management or poor investment decisions. Comparisons should also be made with industry peers and a company's historical ROCE trends to understand its relative performance and long-term trajectory.

Hypothetical Example

Let's consider a hypothetical company, "Diversified Widgets Inc."

Diversified Widgets Inc. Financials:

Earnings Before Interest and Taxes (EBIT): $1,500,000
Total Assets: $8,000,000
Current Liabilities: $2,000,000

Step 1: Calculate Capital Employed
Using the formula: Capital Employed = Total Assets - Current Liabilities
Capital Employed = $8,000,000 - $2,000,000 = $6,000,000

Step 2: Calculate Return on Capital Employed (ROCE)
Using the formula: ROCE = EBIT / Capital Employed
ROCE = $1,500,000 / $6,000,000 = 0.25 or 25%

This means Diversified Widgets Inc. generates 25 cents in operating profit for every dollar of capital it employs. This ROCE of 25% would then be compared to industry averages and the company's cost of capital to determine its efficiency. A strong ROCE can signal effective management of capital expenditure and operational efficiency.

Practical Applications

Return on capital employed is a versatile metric used across various financial analyses:

Investment Analysis: Investors use ROCE to assess a company's efficiency and potential for generating future net income. Companies with consistently high ROCE often indicate a durable business model and strong management.
Competitive Benchmarking: ROCE is particularly effective when comparing companies within the same industry, especially capital-intensive sectors like manufacturing, utilities, or telecommunications. It helps identify which companies are best at turning their investments into profits.
Capital Allocation Decisions: For management, ROCE informs capital allocation strategies, guiding where to deploy capital for the highest returns. Decisions on reinvestment, acquisitions, or returning capital to shareholders are often influenced by ROCE.
Corporate Reporting and Disclosure: Public companies often discuss their capital efficiency and resource utilization in their financial reports, particularly in the Management's Discussion and Analysis (MD&A) section, which provides a narrative explanation of the company's financial condition and results of operations.⁵, ⁶ This section, as outlined by the Securities and Exchange Commission (SEC), aims to provide investors with insights into the company's performance "through the eyes of management."³, ⁴
Strategic Planning: Businesses employ ROCE to evaluate the effectiveness of their long-term strategies and identify areas for operational improvement to enhance capital productivity, which is critical for value creation. Harvard Business Review emphasizes that capital allocation is a fundamental responsibility of CEOs, impacting a firm's long-term success.²

Limitations and Criticisms

While Return on Capital Employed (ROCE) is a valuable metric, it has several limitations and criticisms:

Reliance on Accounting Data: ROCE is based on historical accounting data, which may not always reflect a company's true economic value or future prospects. Accounting practices, such as depreciation methods or asset revaluations, can significantly impact the "capital employed" figure. Challenges in accurately measuring capital services for productivity analysis are well-documented in economic research.¹
Industry Specificity: ROCE is best used for comparing companies within the same industry, as capital intensity varies greatly across sectors. A high ROCE in a service-based business might be misleading when compared to a low ROCE in a heavy manufacturing company, even if both are performing well relative to their respective industries.
Ignores Cost of Capital: While a higher ROCE is generally better, it doesn't explicitly factor in the company's weighted average cost of capital (WACC). A high ROCE might still be insufficient if the cost of funding that capital is even higher.
Temporal Snapshot: ROCE is a snapshot in time. A single period's ROCE might not be indicative of long-term trends, and it doesn't account for cyclical variations in profitability or significant capital expenditure cycles.
Impact of Debt vs. Equity: The calculation of capital employed pools debt and equity together. This can mask differences in how a company funds its operations, potentially overlooking higher financial risk associated with greater reliance on debt.

Return on Capital Employed vs. Return on Invested Capital

Return on Capital Employed (ROCE) and Return on Invested Capital (ROIC) are both profitability ratios that assess how effectively a company uses its capital to generate returns, and they are often used interchangeably or confused. However, there is a subtle but important distinction.

ROCE typically defines "capital employed" as total assets minus current liabilities, or simply shareholders' equity plus long-term debt. This emphasizes the long-term capital used in the business. ROIC, on the other hand, often calculates "invested capital" more precisely, usually as net working capital plus property, plant, and equipment (PP&E), or sometimes as total debt plus shareholders' equity minus non-operating cash. While their formulas are very similar and can sometimes lead to identical results depending on how "capital" is defined, ROIC is generally considered a more refined measure, aiming to capture the capital directly deployed in core operating activities. The core difference lies in the specific adjustments made to the capital base, with ROIC often attempting to exclude non-operating assets or short-term liabilities that aren't directly funding revenue-generating operations. Both metrics aim to show how much profit a company generates per dollar of capital, but ROIC attempts a purer focus on operating capital.

FAQs

What is a good ROCE?

There's no single "good" ROCE number, as it varies significantly by industry. Generally, a ROCE that is higher than a company's cost of capital and consistently higher than its industry peers indicates strong performance. For example, a ROCE of 15% might be excellent for a utility company but merely average for a high-growth technology firm.

Can ROCE be negative?

Yes, ROCE can be negative if a company's earnings before interest and taxes (EBIT) are negative, meaning the company is incurring an operating loss. A negative ROCE signifies that the company is not generating sufficient profits to cover its operational costs from the capital it has employed, which is a significant concern for investors.

How does ROCE differ from Return on Equity (ROE)?

ROCE measures the return generated from all capital (debt and equity) used in the business, focusing on operational efficiency before financing costs and taxes. Return on Equity (ROE) measures the net income generated per dollar of shareholders' equity. ROE specifically focuses on the return to equity investors after all expenses, including interest and taxes. ROCE is generally preferred for assessing the core profitability of a business regardless of its financing structure.

Why is capital employed calculated in two ways?

Capital employed can be calculated as either total assets minus current liabilities or as shareholders' equity plus long-term debt because both methods arrive at the same figure: the total long-term funds invested in the business. The first method focuses on the asset side of the balance sheet, while the second focuses on the financing side, but they ultimately represent the same pool of capital.