How efficiently a company turns capital into profit is a good indicator of how well it is operating. Return on capital employed (ROCE) is a financial ratio used by business owners, shareholders, and potential investors to do just that – assess the profitability of a business.
Read on to find out what ROCE is, why and how to calculate it, which circumstances this metric is most suited to, and how business owners can improve their ROCE.
What Is Return on Capital Employed (ROCE)?
At a high level, ROCE indicates the total profit a business generates per $1 of capital employed. The more profit a company makes per $1 of capital employed, the more profitable it is relative to all of its capital.
However, understanding the nuances of ROCE is essential to using it appropriately. Unlike some other profitability ratios, such as return on assets (ROA), ROCE provides a more comprehensive assessment of profitability by considering all of a company’s sources of capital, including both equity and debt. ROA, in contrast, measures a company’s profitability solely in relation to its total assets, without accounting for how the company is financed.
A rule of thumb is that you should try to aim for a ROCE of at least 15%, but the averages differ from industry to industry, so how well you’re doing depends on what sector you’re in.
This distinction makes ROCE particularly valuable for companies in capital-intensive sectors, where significant levels of debt are the norm. ROCE effectively evaluates how well such debt is being turned into profits. Conversely, ROCE may not be the best measure of profitability for companies with large, unused cash reserves, as these reserves can disproportionately increase the capital employed. This can lead to a lower ROCE – one that does not necessarily reflect operational inefficiency.
How to Calculate Return on Capital Employed (ROCE)
The formula for calculating ROCE is:
ROCE = EBIT/Capital Employed
- EBIT, also known as operating income, refers to a company’s earnings before interest and tax.
- Capital employed refers to the total amount of capital a business uses to acquire profits.
Capital employed can be calculated using one of two formulas:
Capital Employed = Total Assets – Current Liabilities
Or
Capital Employed = Fixed Assets + Working Capital
ROCE is typically expressed as a percentage. So, if a company has an EBIT of $5,000 and capital employed of $25,000, it has a ROCE of 20% ($5,000 / $25,000 = 0.2, or 20%).
What is a Good ROCE Value?
Since ROCE reflects the profitability of a business, generally speaking, the higher the percentage, the better. A low ROCE may indicate the company is not efficiently using its capital employed, and thus is not generating a good return on investments.
A rule of thumb is that you should try to aim for a ROCE of at least 15%, but the averages differ from industry to industry, so how well you’re doing depends on what sector you’re in. In manufacturing, ROCE can exceed 25%, whereas in retail it typically ranges from 5% to 15%.
Advantages and Disadvantages of ROCE
ROCE is one of several financial ratios that business owners, shareholders, and investors may use to assess profitability performance in order to guide decisions about investment, lending, negotiating equity, or simply benchmark performance.
It’s important to understand the advantages and disadvantages of ROCE in order to determine when and how to best use it.
Advantages of ROCE
The key benefit of ROCE is that it provides a comparison of profitability relative to both equity and debt. So, when it comes to assessing profitability of companies in capital-intensive sectors, ROCE may be a better metric to focus on than return on equity (ROE), which looks at profitability relative only to shareholder equity and does not account for the significant debt that such companies tend to have.
For business owners, ROCE can also be a helpful tool for identifying ways to boost efficiency and profitability. They might analyze their ROCE over time with an eye toward which of their assets are generating the greatest returns, for example.
ROCE can also prove valuable in comparing companies of similar scale that operate within the same industry, as the expectations for ROCE performance should be similar.
Disadvantages of ROCE
It stands to reason then that ROCE can be misleading when comparing businesses operating in different industries or at different phases of development. It’s possible that a software company with a 30% ROCE may be just as successful at an oil company operating at 15% ROCE. Therefore, ROCE should not be used to compare companies in different sectors.
ROCE also has limitations as a standalone metric, as it focuses solely on use of capital. For that reason, it's often best used in combination with other metrics. Looking at ROCE in conjunction with the weight average cost of capital (WACC), for instance, should reveal whether a business’s return on capital is outpacing the cost of its funding (WACC refers to the average rate that a company pays to finance its business). Often, investors can look at ROCE alongside other profitability metrics like return on equity (ROE) and return on invested capital (ROIC), to get a fuller picture of financial performance.
Additionally, ROCE does not account for other factors that can impact company performance, like changing economic conditions or inflation, which may boost or erode profits in a way that skews the ROCE picture. It’s also important to note that ROCE is a historical metric, based purely on past financial results, and should be viewed as such. In other words, it’s generally best not to heavily rely on ROCE to interpret current conditions or future opportunities.
How to Help Improve ROCE
Companies that want to boost their appeal to investors and shareholders should aim to increase their ROCE over time. There are a number of ways business leaders can go about improving ROCE, including:
Streamlining Operations
Any efforts a company makes to improve efficiency or reduce waste can have a positive impact on ROCE, such as adopting new software and automation tools, enacting process improvements, or improving workforce productivity. But it’s always important to take a long-term view. Some decisions that might improve ROCE in the near-term, such as reducing headcount, could erode performance and profitability over time.
Reallocating Capital
Effective capital allocation can be the key to a good ROCE. Aim to prioritize capital investments based on their likely returns and alignment with strategic objectives. Companies can also lift ROCE by cutting underperforming investments and projects. Instead, try to focus on the initiatives that can best benefit working capital management, such as better inventory controls or streamlining collections.
Optimizing Assets
Maximizing returns on existing assets can also have a positive impact on ROCE. Companies may decide to sell underperforming or underutilized assets, renegotiate leases, or explore shared asset ownership models in order to strengthen their ROCE.
Improving Margins
Companies can also take steps to boost their returns. For example, business owners might review their pricing strategies, sales tactics, customer relationships, and growth strategies with an eye toward boosting profits – potentially boosting ROCE in turn. The key here is to boost EBIT without a proportional increase in capital employed.
The Bottom Line
ROCE can be a key metric of business success, illustrating how well a company uses its assets to deliver a profit. Indeed, investors and shareholders frequently look at a company’s ROCE to make decisions to invest or divest, to negotiate equity, or make lending decisions. A clear understanding of the benefits and limits of this profitability measure can also help business owners better manage their own ROCE and, in turn, their attractiveness to investors and shareholders.
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