Definition of Return on Capital Employed (ROCE)
Return on Capital Employed (ROCE) is a critical accounting ratio that provides insight into an organization’s profitability and the efficiency with which its capital is utilized. ROCE is calculated as:
\[ \text{ROCE} = \frac{\text{Earnings Before Interest and Tax (EBIT)}}{\text{Capital Employed}} \times 100% \]
Where:
- Earnings Before Interest and Tax (EBIT) represents the operating profit of the company.
- Capital Employed is typically defined as total assets minus current liabilities but can also be calculated as fixed assets plus current assets minus current liabilities.
This ratio is particularly significant for assessing the performance of companies in capital-intensive industries and helps investors and management understand how well the company is generating profits from its capital base.
Examples
Example 1: Single Company Analysis
ABC Corp has the following financial data for the accounting period:
- EBIT: $200,000
- Fixed Assets: $500,000
- Current Assets: $300,000
- Current Liabilities: $100,000
Capital Employed = Fixed Assets + Current Assets - Current Liabilities \[ = $500,000 + $300,000 - $100,000 \] \[ = $700,000 \]
ROCE = \(\frac{$200,000}{$700,000} \times 100%\) \[ = 28.57% \]
Example 2: Division Comparison
A company with three divisions reports the following EBIT and capital employed:
| Division | EBIT | Capital Employed | ROCE |
|---|---|---|---|
| North | $50,000 | $200,000 | 25% |
| South | $70,000 | $350,000 | 20% |
| East | $30,000 | $250,000 | 12% |
The North Division has the highest ROCE, indicating it is the most efficient in utilizing its capital employed.
Frequently Asked Questions (FAQs)
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Why is ROCE important?
- ROCE is important because it provides a clear picture of how efficiently a company is using its capital to generate profits. It helps in comparing the performance of companies in the same industry.
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How is ROCE different from ROI?
- ROCE specifically considers the capital employed, while ROI is a broader term that can vary in its definition. ROI could consider net profit over total investment, which may include total liabilities.
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What is a good ROCE percentage?
- A good ROCE percentage can vary by industry, but generally, a ROCE higher than the cost of capital is considered favorable.
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Does ROCE account for a company’s debt?
- Yes, ROCE indirectly considers debt by taking into account current liabilities when calculating capital employed.
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Can ROCE be used in conjunction with other metrics?
- Absolutely. ROCE should be used alongside other performance measures like residual income, profit margins, and capital turnover ratios to get a comprehensive view of a company’s performance.
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Can ROCE be negative?
- Yes, ROCE can be negative if the EBIT is negative, indicating that the company is operating at a loss.
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Does ROCE fluctuate over time?
- Yes, ROCE can change over different accounting periods based on changes in EBIT and capital employed.
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What does a declining ROCE indicate?
- A declining ROCE may indicate that a company is becoming less efficient at generating profits from its capital.
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Is ROCE affected by asset sales?
- Yes, asset sales can impact the capital employed and therefore affect the ROCE.
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How does ROCE benefit managers?
- ROCE helps managers understand the effectiveness of their investment decisions and prompts them to improve the capital allocation.
Related Terms
Capital Turnover
An efficiency ratio that measures the company’s revenue generated per dollar of capital employed.
Residual Income
The amount of income that an organization generates in excess of its required return on capital.
EBIT (Earnings Before Interest and Taxes)
A measure of a company’s profitability that excludes interest and income tax expenses.
Current Assets
Assets that are expected to convert to cash within one year.
Fixed Assets
Long-term tangible assets used in the operations of a business.
Current Liabilities
Obligations of a company that are due within one year.
Online References
- Investopedia: Return on Capital Employed (ROCE)
- Corporate Finance Institute: ROCE
- Financial Times Lexicon: ROCE
Suggested Books for Further Studies
- Financial Accounting: An Introduction by Pauline Weetman
- Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, Franklin Allen
- Corporate Finance Theory and Practice by Aswath Damodaran
- Essentials of Accounting by Robert N. Anthony, Leslie Pearlman
Accounting Basics: “Return on Capital Employed (ROCE)” Fundamentals Quiz
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