What is the Return on Capital Employed (ROCE)?

Return on Capital Employed (ROCE) is an important financial ratio that is used to analyse the profitability and capital efficiency of the firm.

In order to provide a comprehensive picture of the company's financial performance, ROCE considers both debt and equity. A high and consistent ROCE shows that the business is doing a good job of managing its capital.

This article explores the return on capital employed meaning, how to calculate it, and why it matters.

What is Return on Capital Employed?

Return on capital employed (ROCE) is a financial ratio that measures how efficiently a company uses it capital. It shows the ability of the enterprise to generate returns on the total capital invested, which includes equity as well as debt but excludes short-term debt.

Investors use ROCE to assess the capital efficiency of the management, compare performances of different companies, and identify investment opportunity with high return potential. A high ROCE indicates that the company is able to generate high returns on its investment and carries superior growth potential.

Return on Capital Employed Ratio Formula

The return on capital employed ratio formula (ROCE) is-

ROCE = EBIT / Capital Employed

Where,

1. EBIT (Earnings Before Interest and Tax) is the company’s total profits before deducting any interest or tax payments.

2. Capital employed is the total amount of capital invested in the business minus the current liabilities.

Now, let's take an example and look at Company XYZ Ltd. to see how to calculate the return on capital employed.

Say, a company XYZ Ltd. has an EBIT of ₹200 crores. This is the profit before paying any interest or taxes. They have total assets of ₹600 crores and current liabilities of ₹200 crores.

To find capital employed, we subtract current liabilities from total assets

Capital employed = ₹600 crores - ₹200 crores = ₹400 crores

Now, ROCE = EBIT / capital employed

= ₹200 crores/ ₹400 crores = 0.5 or 50%.

This means XYZ Ltd. generates a return of ₹50 for every ₹100 capital employed. In other words, the company makes a profit of 50% from the money it has invested.

Examples of the Capital Employed Formula

Let’s understand how ROCE formula works with an example-

Consider a company has generated a net operating profit of ₹1 crore and has total current assets of ₹6 crores and total current liabilities of ₹2 crores.

Using the formula-

Capital Employed = Total Assets – Current Liabilities

Capital Employed = ₹6,00,00,000 - ₹2,00,00,000 = ₹4,00,00,000

ROCE = EBIT/Capital Employed

= 1,00,00,000/4,00,00,000 = 25%

Importance of ROCE

• ROCE shows how well a company utilises its capital to generate profits, offering insights into operational effectiveness.
• It allows investors to compare the performance of companies within the same industry, highlighting those with better capital efficiency.
• A consistently high ROCE suggests that a business is capable of sustaining long-term returns on its investments.
• Businesses use ROCE to evaluate the profitability of various projects or investments, ensuring optimal capital allocation.
• A higher ROCE signals financial health and efficiency, making the company appealing to potential investors.

Pros and Cons of ROCE

Here are the pros and cons of ROCE

Conclusion

ROCE is a valuable tool you can use to understand how effectively a company uses its capital to generate profits. It is also very useful for assessing businesses in capital-intensive industries and comparing similar companies.

FAQs

What is ROCE?

ROCE (Return on Capital Employed) measures a company's profitability and how efficiently it uses its capital to generate returns. It’s a key metric for evaluating overall operational performance.

How is ROCE calculated?

ROCE is calculated using the formula:

ROCE = Earnings Before Interest and Tax (EBIT)/Capital Employed, where capital employed is total assets minus current liabilities.

Why is ROCE important when we also have ROE and ROA metrics?

ROCE considers both equity and debt, providing a holistic view of profitability compared to ROE (focuses on equity) and ROA (focuses on total assets). It is a key metric for understanding how efficiently overall capital is utilised.

What constitutes a good ROCE value?

A ROCE value of at least 20% is considered good. Generally, higher ROCE indicates effective capital utilisation and profitability, but benchmarks can vary by sector.

What does it imply to say that capital is being used?

Capital being used refers to how a company employs its financial resources—equity and debt—for operational activities, investments, and generating profits. Efficient use of capital ensures higher returns and sustainable growth.