The objective of every business entity is to earn profits, and this is possible only if it functions in an efficient manner. For this, a company must ensure to optimally utilize its funds and available capital. It is also important for a company to periodically compare its efficiency against a benchmark or competitors. To measure its efficiency and performance from time to time, a business needs to have a financial tool or a ratio. This is where the return on capital employed comes into picture, as it helps a company to compare its efficiency against others within the same industry or sector.
What is Return on Capital Employed (ROCE)?
Return on capital employed or ROCE helps in estimating a company’s efficiency of earning profits using its available capital. It is represented in a ratio form and mainly helps highlight how efficient a business may be.
ROCE is a profitability ratio which compares a company’s net operating profit to its capital employed. It tells how much is generated in profits by every rupee of capital employed by the company.
ROCE importance and limitations
Investors who invest in the stock market must know some of the basics of the markets and terms related to such investments. Alongside, it is also important to learn about fundamental and technical analysis to gain expertise in identifying the right stocks for investment.
Importance:
- It helps evaluate a company’s ability to generate profits from its invested capital
- ROCE can be compared with other companies in the same industry to see if a company is outperforming or underperforming its peers
- Can be used to make investment decisions and evaluate the overall financial health of a company
Limitations:
- It only considers the invested capital, ignoring other sources of financing like debt
- ROCE can be manipulated by creative accounting techniques
- Different companies may have different ways of calculating their invested capital, leading to inconsistent results.
Formula for Return on Capital Employed
The formula for Return on Capital Employed is based on two key parameters:
- Operating profit,
- Capital employed
Net operating profit, also known as earnings before interest and taxes or EBIT, includes profits and excludes interest and taxes.
Capital employed = Total assets – current liabilities
The formula for ROCE is therefore:
| ROCE = EBIT/Capital Employed |
How to use and interpret ROCE?
Here is how investors and stakeholders can interpret ROCE results:
- A comparatively higher ROCE indicates that a company has been able to utilise its capital more efficiently
- Since the ROCE ratio considers debt and other liabilities instead of only profitability of a company, it helps in comparing companies within capital-intensive sectors, such as telecom and power.
- A company that shows a stable ROCE over many years is considered having excellent performance. Investors mostly prefer such companies that reflect a consistent rise in ROCE as against those which show fluctuating ROCE.
It is important to note, for investors, that comparing only ROCE results of two companies may not offer a holistic picture about the company’s performance. Therefore, they must consider other factors that are part of fundamental and technical analysis.
Calculating ROCE
Lets us understand the application of the ROCE formula with an example:
Assume that:
- company ABC has an EBIT of Rs. 200 crores in a financial year.
- company XYZ has an EBIT of Rs. 150 crores in the same financial year.
One may interpret this as company ABC having a better investment, since its EBIT is higher. However, this is not the right interpretation as far as the profitability of the company is concerned. To understand these figures correctly, one must look at the ROCE of both these companies.
Using the same example, let’s assume that:
- capital employed by company ABC is Rs. 1,000 crores
- capital employed by company XYZ is Rs. 600 crores
ROCE of company ABC = 200/1000 = 20%
ROCE of company XYZ = 150/600 = 25%
The ROCE formula shows us that returns for company ABC are 20% and that of company XYZ are 25%. Thus, ROCE shows that company XYZ may be a better investment as compared to company ABC.
Advantages and Disadvantages of ROCE
Some of the advantages of ROCE are:
- ROCE helps in capturing the monetary returns on equity and debt. Thus, it is used by investors as a criterion for establishing an investment portfolio and designing investment strategies.
- It can be used in comparing companies that have different capital structures. Thus, it is a good tool that can be used by companies for peer comparison.
Here are a few of the limitations of ROCE
- ROCE is prone to the risk of accounting manipulation, resulting in elevated returns. One such example is classifying long-term liabilities as current liabilities.
- Since this ratio is based on book value, the returns may not be reflective of the market value. As the company’s assets depreciate, the ROCE goes up despite cash flows remaining constant. This means that businesses that are older and have depreciated assets will have higher ROCEs as compared to new companies.
Example of Return on Capital Employed
Return on Capital Employed (ROCE) is a financial metric used to measure the efficiency and profitability of a company. A simple example could be:
A company has a capital employed (total assets minus current liabilities) of Rs. 100 crore and generates a profit of Rs. 20 crore in a year. The ROCE for the company would be 20% (20 crore / 100 crore). This means the company is generating 20% return on every rupee invested in the business.
Conclusion
As we have seen, ROCE is one of the important financial metrics that can be used by investors to assess the overall return from investing in a company. It overcomes the drawbacks of changing capital structures. However, investors must note that this ratio too is vulnerable to certain accounting misrepresentation. Therefore, one must be vigilant while using ROCE to analyse companies.
FAQs
While both ROCE and ROE are profitability ratios, they are different, in that ROE takes only equity capital into consideration while ROCE takes both equity and debt capital into consideration.
Return on capital employed is often preferred by investors over return on equity (ROE) and return on assets (ROA) as it takes both debt and equity financing into account. It is also a better metric to predict a company’s performance and its profitability in the long run.
Business capital is the company’s total assets after deducting current obligations. Capital utilization is considered by analysts and investors in combination with other financial measures to gauge the returns generated by a company’s assets and how effectively the management has been able to deploy capital.
There is no specific industry standard as far as ROCE is concerned. Since it is viewed in comparison to peers, the greater the value, the more efficient the firm is considered as far as capital utilisation is concerned. A larger ROCE, however, may also indicate that a company has a lot of cash on hand since cash is included in total assets.
Yes, it is possible that a company may have negative ROCE, especially if it has a negative operating profit.
