To monitor business performance, investors measure the amount of profit a company has earned as a percentage to the total capital employed. This financial ratio is known as return on capital employed or ROCE.
ROCE of a company tells you whether the profit is sufficient considering the amount of equity and long-term debt invested to earn money.
Formula to calculate return on capital employed or ROCE
Here is the formula to calculate return on capital employed;
ROCE = {Earnings before interest and tax / (share capital+reserves+long-term loans)} * 100
Profit before payment of interest and tax or EBIT is considered in ROCE calculation because this is the earnings that is available to pay obligations of all providers of finance. It’s also known as operating profit. In simpler terms, operating income or EBIT shows you how much profit a company earns from its operation before paying interest and taxes. You can get EBIT by deducting cost of goods sold and operating expenses from total revenues. You can get EBIT from company’s income statement.
Denominator in above equation is also known as total capital employed, which can be derived by deducting current liabilities from total assets of the company. It’s the total money utilized to generate profit.
To the above equation if you multiply revenue/revenue, then you will get following formula;
ROCE = [{EBIT/(share capital + reserves + long term loans)} * 100] * revenue/ revenue
= {(EBIT/revenue)*100}*{(revenue/total capital employed)*100}
= operating profit margin * asset turnover
From the above equation, its derived that if you multiply operating profit margin with asset turnover, then you will get return on capital employed.
Therefore, Return On Capital Employed depends on following two factors;
- Profitability of sales
- Level of sales achieved from company’s total assets
A high ROCE indicates that the company is efficiently using its equity and long-term debt to be more productive.
While comparing ROCE of one company with another, you need to keep in mind following important points;
- Definition of capital employed can vary. If a company has low debt and high equity in comparison to another company with high debt and low equity then ROCE will not help for comparison. You need to base your decision on other financial ratios to get a clear picture of the company.
- Profitability margin can be higher for a small company in comparison to a large company. Similarly, equity, long-term debt and revenue can be less or more but the ratio will not indicate the size of the company and its market presence.
- Return On Capital Employed can mislead you if the company’s assets has higher market value than the value showing in the balance sheet. For instance, company’s land and buildings are not considered at current market price in the balance sheet.
- If a company has recently invested in fixed assets for future expansion, then the initial ROCE will be low as in general, company takes some time to make money after expansion. In this type of cases, comparison of ROCE with a already established player is not effective.
