Return on Capital Employed (ROCE)
Ratios
Overview
Return on Capital Employed (ROCE) is a profitability ratio that measures how efficient a company is at using its capital to generate profits and use its capital efficiently. ROCE takes into account the total capital that the company has at its disposal and the returns that the company generates over a specified time frame.
The ROCE indicates how much operating profit is generated for each dollar of capital invested in the company. As an efficiency ratio, the higher the ratio, the more efficient the company is at using its capital.
Alternative Names: ROCE
Formula
ROCE = EBIT ÷ Capital Employed
Where Capital Employed is calculated as:
Capital Employed = Total Assets − Current Liabilities
Components: For returns, we use EBIT (Earnings Before Interest and Taxes), which is representative of the company's profit including all expenses except interest and tax expenses. For the capital employed, we use the company's Total Assets minus Current Liabilities, which can also be seen as Shareholders' Equity plus Long-term Debt. EBIT can be found on the income statement, while Total Assets and Current Liabilities are found on the balance sheet.
Calculation Example
Let's calculate the return on capital employed for a hypothetical company to demonstrate the process:
Example Company - Financial Data:
- EBIT (Earnings Before Interest and Taxes): $800,000
- Total Assets: $5,000,000
- Current Liabilities: $1,000,000
Step 1: Calculate Capital Employed
Capital Employed = Total Assets − Current Liabilities
Capital Employed = $5,000,000 − $1,000,000
= $4,000,000
Step 2: Calculate ROCE
ROCE = EBIT ÷ Capital Employed
ROCE = $800,000 ÷ $4,000,000
= 0.20 or 20%
Interpretation: A ROCE of 20% means that for every $1 of capital invested in the company, the business generates $0.20 in operating profit. This indicates strong capital efficiency and suggests the company is effectively using its long-term capital to generate returns.
How to Interpret
ROCE is an efficiency ratio, and therefore the higher the ratio, the more efficient the company is at using its capital. The ROCE indicates how much operating profit is generated for each dollar of capital invested in the company.
General Guidelines:
Below 10%: Poor Capital Efficiency
Low ROCE indicates the company is struggling to generate adequate operating returns from its capital employed. This may signal operational challenges, competitive pressures, or inefficient use of long-term capital. The company is not effectively converting its capital investments into operating profit.
10% - 20%: Acceptable Efficiency
Moderate ROCE represents acceptable performance for many industries. The company is generating reasonable operating returns from its capital employed, comparable to industry averages. Performance is stable but there may be room for improvement in capital efficiency.
Above 20%: Excellent Efficiency
High ROCE indicates the company is highly efficient at using its capital to generate operating profit. This suggests strong operational efficiency, effective capital management, and competitive advantages. Management is successfully converting capital investments into superior operating returns.
Capital-Intensive Sectors: ROCE is especially useful to investors when analyzing the performance of companies in capital-intensive sectors like utilities, mining, and telecommunications. These industries require significant long-term capital investments, making ROCE a critical metric for assessing how efficiently that capital is being deployed.
Book Value Considerations: It is important to notice that since ROCE uses book value of assets, there might be some distortions in how ROCE is affected over time. For example, depreciated assets on the balance sheet will increase the ROCE even though profitability stays the same (as the denominator decreases). Conversely, in higher inflation environments, inflation will affect the earnings but will not have an effect on the book value of assets, which might have a similar distorting effect on ROCE.
Why It Matters
ROCE is an important metric that many investors and analysts use to assess the quality and efficiency of a business. It provides insights into how well management is deploying capital to generate operating returns.
Key Insights:
- Capital Efficiency Assessment: Measures how efficiently a company uses its capital to generate operating profits. Higher ROCE indicates management is more effective at deploying long-term capital (equity plus long-term debt) to create value.
- Operating Profitability Focus: Uses EBIT (Earnings Before Interest and Taxes) as the numerator, which focuses on operating profitability before financing decisions. This allows for cleaner comparison of operational efficiency across companies with different capital structures.
- Capital-Intensive Industry Analysis: ROCE is especially useful when analyzing companies in capital-intensive sectors like utilities, mining, and telecommunications. These industries require significant investments in long-term assets, making capital efficiency a critical determinant of success.
- Long-Term Capital Deployment: By subtracting current liabilities from total assets, ROCE focuses on how efficiently long-term capital is being used. This is equivalent to analyzing returns on shareholders' equity plus long-term debt, highlighting management's effectiveness with permanent capital.
- Quality and Efficiency Indicator: High ROCE signals a quality business with competitive advantages and efficient operations. Investors and analysts use ROCE to identify companies that generate superior returns on the capital they deploy, which often translates to strong long-term performance.
Key Takeaways
- Return on Capital Employed (ROCE) is a profitability ratio measuring how efficient a company is at using its capital to generate profits
- Calculated as EBIT ÷ Capital Employed, where Capital Employed = Total Assets − Current Liabilities
- Uses EBIT (Earnings Before Interest and Taxes), representing company profit including all expenses except interest and tax
- Capital Employed can also be viewed as Shareholders' Equity + Long-term Debt, focusing on permanent capital
- ROCE is an efficiency ratio—higher ratios indicate more efficient use of capital
- Indicates how much operating profit is generated for each dollar of capital invested in the company
- Especially useful for analyzing companies in capital-intensive sectors like utilities, mining, and telecommunications
- Important metric that investors and analysts use to assess the quality and efficiency of a business
- Book value considerations: Depreciated assets increase ROCE even if profitability stays the same (denominator decreases)
- Inflation distortion: Inflation affects earnings but not book value of assets, which can distort ROCE over time
- Must be compared with company historical performance and industry peers for proper context
Related Financial Ratios
These related metrics provide additional insights for comprehensive financial analysis:
Return on Assets (ROA)
Measures profitability relative to total assets. While ROCE focuses on capital employed (total assets minus current liabilities), ROA uses all assets including those funded by current liabilities. ROA provides a broader view of overall asset efficiency.
Return on Equity (ROE)
Measures profitability relative to shareholders' equity only. ROCE includes both equity and long-term debt in the denominator, while ROE focuses solely on equity. ROE shows returns to shareholders, while ROCE shows returns on total permanent capital deployed.
Return on Invested Capital (ROIC)
Evaluates returns generated from all invested capital (debt and equity). Similar to ROCE in focusing on long-term capital efficiency, ROIC may use different adjustments in the numerator (such as NOPAT) to provide a comprehensive view of returns on invested capital.