Return on Capital Employed (ROCE): A Simple Explanation

What Does It Mean?

"Capital Employed" refers to the total funds invested in a company, including both shareholders’ equity and debt. ROCE shows how much profit the company makes for every dollar (or other currency) of capital employed. It’s an important indicator of a company’s ability to create value from its investments.Understanding ROIC: How It Works

How Is ROCE Calculated?

The formula for ROCE is:

ROCE = (EBIT / Capital Employed) X 100

• Earnings Before Interest and Taxes (EBIT): A company’s operating profit before considering interest and taxes.

• Capital Employed: Total assets minus current liabilities, representing the long-term funds used by the business.

Example:
If a company has an EBIT of $1,000,000 and total capital employed of $5,000,000:

ROCE = (1,000,000 / 5,000,000) X 100 = 20%

This means the company generates a 20% return on its capital employed.

ROCE vs. ROE vs. ROC

• ROCE: Measures returns from total capital employed (equity + debt), focusing on operational efficiency.

• ROE: Looks only at returns for shareholders (equity).

• ROC: Similar to ROCE but may use a different definition of capital, often including all long-term funding sources.

What Is a Good ROCE?

A "good" ROCE depends on the industry, but as a rule of thumb, it should be higher than the company’s cost of capital. A consistently high ROCE indicates efficient use of resources and a competitive advantage.

Limitations of ROCE

1. Industry Differences: Capital-intensive industries (like manufacturing) naturally have lower ROCE compared to asset-light industries (like tech).

2. Short-Term Changes: ROCE can fluctuate due to temporary changes in capital employed or EBIT.

3. Focuses Only on Operations: ROCE ignores non-operational income, which may understate total profitability.

Key Takeaways

• ROCE measures how efficiently a company generates profits from its total capital employed.

• It’s calculated as EBIT divided by capital employed, expressed as a percentage.

• A high ROCE indicates efficient use of resources, but comparisons are most meaningful within the same industry.

Understanding ROCE helps investors identify companies that are effectively using their capital to generate strong, sustainable profits. It’s particularly valuable for evaluating capital-intensive businesses.

The information is provided for educational purposes only and does not constitute financial advice or recommendation and should not be considered as such. Do your own research.