Companies ensure that they provide better returns to their investors with the addition of leverage in their total capital, and thus show higher profitability and returns. We also previously understood evaluating a company's profitability and rate of returns to its investors with the use of Return on Assets (ROA) and Return on Equity (ROE) ratios. However, in order to understand how the company is using its total capital, one must know the rate of returns on the total capital employed. This ratio is known as the return on capital employed ratio.
Return on the capital employed ratio is one of the few profitability ratios that an investor evaluates to understand the rate of returns and profitability of a company. ROCE is a financial ratio that can be used to assess a company's profitability and capital efficiency. ROCE helps understand how efficiently a company is using its total capital to generate profits.
Return on Capital Employed is a profitability ratio that helps in understanding how much profit, each rupee of the total capital employed generates. It shows how efficiently a company can generate profits from the capital it has employed in its business operations.
It is a long-term profitability ratio used to evaluate a company's longevity as it considers the performance of its assets with long-term financing in the company.
How to calculate Return on Capital Employed
The Return on Capital Employed ratio consists of two components and their calculations: Earnings before Interest and Tax (EBIT) and Capital Employed.
Return on Capital Employed = Earnings Before Interest and Taxes (EBIT) / Total Capital Employed X 100
where EBIT = Earnings before Interest and Tax
Total Capital Employed = Equity Capital + Debt Capital
1. Earnings before Interest and Tax (EBIT)
EBIT, also known as net operating income, is the indicator of much how much a company has earned from its operations before incurring any costs such as taxes or interests. It is recorded in the company's profit and loss statement and shows the total income a company has earned before any cost deductions. As the name suggests, Earnings before Interests and Tax can be calculated by subtracting the cost of goods sold and operating expenses from revenues or, if needed, by adding the interest and taxes back on the net income.
2. Total Capital Employed
The total capital employed suggests the total amount of capital employed in the business operations, which includes shareholders' equity and the company's assets. Some analysts also calculate it by deducting the current liabilities from the total assets. However, the most common derivation method is by adding equity capital to the company's debt capital.
Example of ROCE calculation
To understand the calculation of Return on Capital Employed ratio, let us take a look at the performance and figures from our previously considered company, ABC Ltd.
ABC Ltd has generated an equity capital of Rs 300 and debt capital (raised at 6% p.a interest rate) of Rs. 200. And the company generates a net operating profit or EBIT of Rs. 86.
ROCE of ABC Ltd = Earnings Before Interest and Taxes (EBIT)Total Capital Employed
= 86/ 300+200
= 0.17 or 17%
What does the ROCE ratio suggest?
A higher EBIT compared to the total capital employed would result in a higher Return on Capital Employed (ROCE) ratio, which means that the total assets or capital employed in the business operations, generate higher returns for the company thus indicating a good financial health.
On the other hand, in case the denominator, i.e., the total capital employed is higher than the EBIT, the ROCE ratio will be lesser. This often means that the company is not putting its capital to its most efficient use, and there's a scope for improvement or can even suggest losses.
The return on capital employed ratio shows how much profit each rupee of employed capital generates. A higher ratio would be more favorable because it means that better profits are generated by every rupee of capital employed.
For instance, a return of .17 of ABC Ltd. indicates that for every rupee invested in capital employed, the company made 17 paise of profits.
Investors calculate the ROCE to evaluate how well a company is using its capital and financial strategies. A company's returns should always be higher than the rate of borrowings or loans that they have taken to fund their assets. In case the ROCE is lower, it means that the company is not operating healthily and cannot generate returns for itself or its investors.
Importance of calculating Return on Capital Employed
Return on Capital Employed is an indicator of a company's profitability based on how efficiently it uses its capital in its business operations. ROCE is an important ratio for an investor to make an investment decision based on a company's return-generating capacity.
- ROCE ratio allows investors to hold a comparison between different companies of the market before making an investment decision. As an investor, one can use ROCE to find out which company most efficiently uses its capital to generate healthy returns.
- ROCE is majorly useful comparing capital intensive businesses that require a bigger amount of heavy capital in its business operations. Such companies include car manufacturing units, airlines, railways, steel manufacturers, etc. These companies have massive investments in their capital, and hence, efficient use of this capital can prove to be a healthy investment opportunity for any potential investor.
- ROCE is a useful measure of financial efficiency since it measures profitability after taking into consideration the amount of capital used to create that level of profitability.
- Using ROCE and ratios such as Return on Assets (ROA) and Return on Equity (ROE) through the DuPont Analysis application can give a holistic view of the company's financial health and return generating capabilities to any potential investor.
- ROCE is useful to compare companies that belong to the same industry.
- Not just for investors, ROCE is a useful metric for the companies as well, as it helps them gauge their performance and point out their strengths and weaknesses, thus leaving scope for performance improvement.
Limitations of Return on Capital Employed
Like most other accounting ratios, the Return on Capital Employed (ROCE) ratio also has some limitations despite its many uses.
- One of the major limitations of ROCE is that although it is highly useful in comparing the financial performances of two companies of the same industry, it doesn't provide accurate details when comparing companies of different industries.
- Using ROCE as a single measure of performance is not effective as it will only provide insight into the company's capital usage. Hence, it is always advisable to team up ROCE ratio with other financial ratios to make better-informed investment decisions.
- Companies with unused cash reserves will show lower ROCE, which can affect the actual result and impact the overall decision. ROCE is not the best measure for companies with large, unused cash reserves.
- ROCE cannot be constant for a period of years, and it will fluctuate year to year, depending upon the company's annual performances in the market. Hence it becomes important to consider ROCE trends over the course of several years when comparing different companies.
The calculation of the Return on Capital Employed Ratio makes it easier to identify the companies that use their capital efficiently. It can be useful for an investor who wishes to invest in a particular industry and has to compare between the top performers of that industry. ROCE has been proven to be very effective in comparing between companies belong to highly capital-intensive industries.
However, ROCE alone cannot be the sole decision making factor. It has several limitations, and just like other accounting ratios, ROCE cannot single-handedly provide the entire picture of a company's financial health. It has to be teamed up with other ratios such as ROA, ROE, and ROIC in order to procure the best possible and the most accurate insight into a company's performance.