Return on Capital Employed (ROCE)
Return on capital employed (ROCE) is a term used for financial statements. It is a financial ratio mostly written in percentage. ROCE measures the profitability and efficiency of a company. It is to ensure and measure how a company can invest all its capital for a long term investment to ensure profit. The efficiency of the company is compared with its capital employed. ROCE is used to evaluate the business gains from its assets and liabilities.
Formula and example for calculating ROCE:
- Current Assets: $500,000
- Fixed Assets: $700,000
- Payable Account: $100,000
- Net income before interest and tax: $200,000
- Interest on long-term loans: $20,000
- ROCE = (Earning Before Interest and Tax (EBIT)/Capital Employed (Total Assets-Current Liabilities)) x 100
- ROCE = ($200,000 – $20,000)/($500,000 + $700,000 – $100,000) x 100
- ROCE = 15%
Capital employed is a very intricate term, because it can be used to refer many different financial ratios. It is a sum of all shareholders equity and the current liabilities of a company. Capital employed has number of ways to be calculated.
Most often Capital employed can be calculated by:
- The total assets of a company less all current liabilities (Total Assets − Current Liabilities).
- A company’s equity plus non-current liabilities (Company Equity + non-Current Liabilities).
- It can also be total fixed assets only.
Earning Before Interest and Tax (EBIT)
Net operating profit or Net income are often terms used for EBIT, the operating income is calculated before any interest or taxes are included, and by interest it means interests on long term investments only.
Significance of return on capital employed
Return on capital employed percentage measures the efficiency of the investment made by the company. The money invested is of the shareholders and creditors in the business and the higher management makes various important financial decisions based on this ratio.
The ROCE should always be higher than the capital cost of the company, which means it should always be higher than what company is borrowing because if the borrowing increases it is likely that the shareholders and creditors earnings will be reduced which can be a threat for company financial matters. For example a company borrows 20% and it produces 10%, which means the company is losing the invested money.
The return on capital ratio shows profit in dollars of capital employed, the higher the rate more profits in dollars will be generated by each dollar invested.