Return on Capital Employed (ROCE)

Return On Capital Employed (ROCE)

A financial ratio that indicates the efficiency and profitability of a company's capital investments.

Calculated by dividing operating income by capital employed:


ROCE =

Operating Income
_____________
Capital Employed


ROCE should always be higher than the rate at which the company borrows, otherwise any increase in borrowing will reduce shareholders' earnings.

A 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.

Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company is realising from its capital employed. The ratio can also be seen as representing the efficiency with which capital is being utilised to generate revenue. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital.

Application of ROCE

ROCE is used to prove the value the business gains from its assets and liabilities, a business which owns lots of land but has little profit will have a smaller ROCE to a business which owns little land but makes the same profit.

It basically can be used to show how much a business is gaining for its assets, or how much it is losing for its liabilities.

Drawbacks of Return On Capital Employed Ratio

The main drawback of ROCE is that it measures return against the book value of assets in the business. As these are depreciated the Return On Capital Employed will increase even though cash flow has remained the same. Thus, older businesses with depreciated assets will tend to have higher Return On Capital Employed than newer, possibly better businesses. In addition, while cash flow is affected by inflation, the book value of assets is not. Consequently revenues increase with inflation while capital employed generally does not: as the book value of assets is not affected by inflation.

Notes:
The terms used in calculation of ROCE

Operating income

In the numerator we have Pretax operating profit or operating income. In the absence of non-operating income, operating income agrees with EBIT; otherwise, it can be derived from EBIT by subtracting non-operating income.

Capital Employed

In the denominator we have net assets or capital employed instead of total assets (which is the case of Return on Assets). Capital Employed has many definitions. In general it is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities or fixed assets plus working capital.

ROCE uses the reported (period end) capital numbers; if one instead uses the average of the opening and closing capital for the period, one obtains Return on Average Capital Employed (ROACE).