Return on Capital Employed
- Return on Capital Employed (ROCE) is used in finance as a measure of returns that a company is realizing from its capital employed.
- Capital Employed is represented as total assets minus current liabilities. In other words, it is the value of the assets that contribute to a company’s ability to generate revenue.
- ROCE is thus a ratio that indicates the efficiency and profitability of a company’s capital investments (stocks, shares and long term liabilities).
Return on Capital Employed (ROCE)
It is expressed as:-
ROCE = Earnings / Capital Employed X 100
- The numerator is Earnings before Interest & Tax. It is net revenue after all the operating expenses are deducted.
- The denominator (capital employed) denotes sources of funds such as equity and short-term debt financing which is used for the day-to-day running of the company.
What does ROCE say…
- It is a useful measurement for comparing the relative profitability of companies.
- ROCE does not consider profit margins (percentage of profit) alone but also considers the amount of capital utilized for those profits to happen.
- It is possible that a company’s profit margin is higher than that of another company, but its ability to get better return on its capital may be lower.
So, ROCE is a measure of efficiency also
For Example…
Company A makes a profit of Rs.200/- on sales of Rs.2000/-
Company B makes a profit of Rs.300/- on sales of Rs.2000/-
In terms of pure profitability, Company B has profitability of 15% (Rs.300/- / Rs.2000/-) x 100
This is far ahead of company A which has 10% profitability (Rs.200/- / Rs.2000/-) x 100
Now…
- Let us assume that Company A had employed Rs.1000/- of capital and Company B used Rs.2000/- to earn their respective profits.
So, ROCE of A is:- (earnings / capital employed)
- (Rs.200/- / 1000/-) X 100 = 20%
- While ROCE of B is:-
- (Rs.300/- / 2000/-) X 100 = 15%
- Thus, ROCE shows us that Company A makes better use of its capital, though its profit percentage is lower than that of Company B.
- In other words, it is able to squeeze more earnings out of every rupee of capital it employs.
Usually…
- ROCE should always be higher than the cost of borrowing.
- An increase in the company’s borrowings will put an additional debt burden on the company and will reduce shareholders’ earnings.
- So, as a thumb rule, a ROCE of 20% or more is considered very good.
- If a company has a low ROCE, it means that it is using its resources inefficiently, even if its profit margin is high.