Return On Capital Employed (ROCE)

Definition

Return on capital employed (ROCE) is a measure of the returns that a business is achieving from the capital employed, usually expressed in percentage terms. Capital employed equals a company's Equity plus Non-current liabilities (or Total Assets − Current Liabilities), in other words all the long-term funds used by the company. ROCE indicates the efficiency and profitability of a company's capital investments.

ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice versa; a good ROCE is one that is greater than the rate at which the company borrows.

Calculation (Formula)

ROCE is calculated by dividing a company's earnings before interest and taxes (EBIT) by its total capital employed, and is usually expressed as a percentage. The formula for calculating ROCE is as follows:

ROCE = $10 million / $60 million = 0.1667 or 16.67%

A more accurate variation of this ratio is return on average capital employed (ROACE), which takes the average of opening and closing capital employed for the time period.

One limitation of ROCE is the fact that it does not account for the depreciation and amortization of the capital employed. Because capital employed is in the denominator, a company with depreciated assets may find its ROCE increases without an actual increase in profit.

ROCE provides insight into how effectively a company is utilizing its capital to generate profits. A higher ROCE indicates that the company is generating more profits per dollar of capital employed, which is generally considered a positive indicator of financial performance. In contrast, a lower ROCE may indicate that the company is not generating sufficient returns on its capital investment and may need to re-evaluate its strategy.

ROCE is particularly useful in comparing the performance of companies in the same industry, as it provides a standard measure of how well each company is utilizing its capital. It is also a valuable tool for investors and analysts in evaluating the financial health and performance of a company.

Negative Return on Capital Employed

A negative ROCE means that the firm's operational earnings (EBIT) were insufficient to cover the cost of the capital used in its operations, which means that the company has experienced a loss on the capital used in its operations.

Several factors, including a fall in income or profitability, large levels of debt or interest payments, or substantial capital expenditures, might result in a negative ROCE. In some cases, a negative ROCE may be a temporary situation that can be corrected through changes in strategy or improved financial performance. However, a sustained negative ROCE may indicate serious financial difficulties and may be a warning sign for investors or creditors.

It is important to note that a negative ROCE should be analyzed in the context of the company's industry and business model, as well as the overall economic conditions. Some industries or business models may require a longer time horizon for generating returns on capital employed, and may have lower or negative ROCE in the early stages of operation. In addition, economic downturns or disruptions can impact a company's financial performance and may lead to negative ROCE in the short term. Before making any investment or financing decisions, it is crucial to assess the causes of a low ROCE and take the company's long-term prospects into account. 

ROCE Formula in ReadyRatios Analysis Software

ROCE (ROACE) = EBIT*(365/NUM_DAYS) / ((F1[b][Equity] + F1[b][NoncurrentLiabilities]+F1[e][Equity] + F1[e][NoncurrentLiabilities])/2)

F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]eginnig and at the [e]nd of the analizing period).
NUM_DAYS – Number of days in the the analizing period.
365 – Days in a year. 

Ratios Similar to ROCE

There are several financial ratios that are similar to Return on Capital Employed (ROCE) and are used to evaluate a company's profitability and efficiency in generating returns from its capital investment. Some of the most commonly used ratios similar to ROCE include:

1. Return on Investment (ROI): ROI is a ratio that measures the profitability of an investment, typically expressed as a percentage of the initial investment. Like ROCE, ROI measures the returns generated by the capital employed in the business, but it is often used to evaluate the returns of specific investments, rather than the overall business.

2. Return on Equity (ROE): ROE is a ratio that measures the profitability of a company's equity investment, usually expressed as a percentage. ROE measures the returns generated by the shareholders' equity, and is often used to evaluate the company's ability to generate profits for its shareholders.

3. Return on Assets (ROA): ROA is a ratio that measures a company's ability to generate profits from its total assets, usually expressed as a percentage. ROA measures the efficiency of a company's use of its assets to generate profits, and is often used to compare the performance of companies in the same industry.

While these ratios are comparable to ROCE, each offers a distinct viewpoint on a company's profitability and efficiency, and depending on the particular situation and industry, may be more or less relevant. To obtain a thorough knowledge of a company's financial performance, it is crucial to employ a combination of ratios and other financial measurements.