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 word, the company makes a profit of 50% from the money it has invested.

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.