Understanding the Return on Capital Employed

Once you enter the stock market for investing, you might get confused about which company you should invest in. In this situation, a return on capital employed (ROCE) can help you.

An ROCE ratio can help you in determining how effectively a company can generate revenue from its capital. This blog explains how to calculate return on capital employed and the importance of using it.

What is ROCE?

The return on capital employed is a financial indicator that measures how effectively a company earns profits from its capital. This can help you review the financial health of different companies and invest in one.

The capital employed refers to the entire capital a company uses to generate profits, which includes both equity and debt. ROCE helps you find out the companies to invest in, which can generate returns for you.

ROCE becomes effective when comparing companies in capital-intensive industries, such as the telecom industry. While the Return on Equity (ROE) metric only considers profitability in contrast to shareholders’ equity, the ROCE excels in debt and equity.

How Do You Calculate Return on Capital Employed?

Using the formula below, you can calculate the ROCE:

ROCE = EBIT / Capital Employed

This provides a clear picture of how effectively your chosen company is earning profits from its capital. Let us discuss what EBIT and capital employed are in this formula:

1. Earnings Before Interest and Taxes

An EBIT is the company’s earned profit before deducting any interest payments or income tax expenses. It helps to determine the operational profitability of a company.

2. Capital employed

You can get the total capital employed by subtracting the total assets from current liabilities. This is the total capital that is used in the business, which includes both equity and debt.

Examples of the ROCE formula

To understand the calculation of ROCE more clearly, let us use an example. In 2024, company X had generated a net operating profit of INR 20 lakh, with total assets of INR 1.40 crore and total current liabilities of INR 60 lakh, respectively. According to these facts, the ROCE of company X will be:

ROCE = EBIT / Capital Employed

ROCE = EBIT / (Total Assets – Total Current Liabilities)

ROCE = INR 20 lakh / (INR 1.40 crore – INR 60 lakh)

ROCE = 0.25 or 25% in 2024

This means that company X generates a return of INR 25 for every INR 100 of capital they employ.

An ROCE of 25% is a strong indicator and suggests that company X is efficient in maximising the returns on the total capital it has invested.

As a result, an ROCE not only helps to analyse a company’s capital efficiency, but also assists in comparing different companies and choosing one to invest in.

What Does ROCE Indicate?

Now that you have understood the return on capital employed meaning and its calculation, you should know the indication of ROCE. Using the indication of the return on capital employed ratio, you can compare the performance of companies in capital-intensive industries.

As you can see in the above example, company X generates a return of 25 paise for each INR 1 of capital they employ. The more revenue per INR 1 a company can generate, the higher the possibility of the company’s profitability.

While analysing a company, the ROCE trend can also be a crucial indicator of its performance. Most of the investors invest in companies with rising ROCE levels over companies whose ROCE is trending lower.

Benefits of ROCE

1. Easy Comparison for Companies

One of the primary benefits of using ROCE is that you can analyse companies operating in the same sector. ROCE is useful for companies from capital-intensive industries like airlines or steel production.

2. Financial Efficiency

The return on capital employed indicator helps you measure a company’s profitability in terms of how effectively it utilises its capital in its operations. ROCE is an essential metric which helps you find the best company to invest in to get desired returns.

3. Industry-Specific Insights

The ROCE is an effective indicator which assists in analysing companies from the same industry. It shows the efficiency of the companies employing their capital in operations, which helps you make informed investment decisions among competitors.

4. Assessing Business Performance

ROCE also serves as a performance benchmark, which helps companies to analyse their strengths and weaknesses. As a result, companies are able to identify their areas of improvement and employ strategies to enhance profitability.

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Limitations of ROCE

1. Lacks Accuracy

The ROCE is beneficial when you compare the financial performances of companies in the same industry. However, it lacks accurate data when comparing companies from different industries.

2. Not Appropriate for All Business Types

ROCE is an inappropriate metric for companies with sizable cash reserves. Companies that have underutilised their cash reserves will have a lower ROCE.

3. Inconsistency

ROCE cannot maintain consistency over time and can change each year according to the company’s market performance. Hence, ROCE may differ when you compare different companies.

Differences Between ROCE and ROIC

While analysing a company’s profitability efficiency in terms of capital, you can use both ROIC and ROCE. Here are the key differences between an ROCE and ROIC:

Factors Affecting ROCE in the Stock Market

ROCE cannot be the same every time because there are some factors that can affect it. Which are explained below:

1. Intensity of Capital

The intensity of a company’s capital can affect its ROCE. Companies having significant fixed assets can have lower ROCE since a higher capital base can weaken returns. Companies should use their capital efficiently to maintain a favourable ROCE.

2. Profitability

Companies with higher profitability have decent ROCE. Factors such as cost structure, pricing power, and operational efficiency drive the possibility. This means companies which optimise their costs can have a higher ROCE.

3. Financial Leverage

ROCE can also be impacted by the level of financial leverage. To increase their ROCE, companies can use debt financing as an affordable approach and generate returns on equity.

4. Economic Conditions

Economic downturns or recessions may reduce the demand and increase the costs of companies. This may lead to a reduced ROCE. On the other hand, favourable economic conditions may increase ROCE by boosting profitability. You must understand these factors to evaluate a company’s efficiency in generating returns from its employed capital.

Final Thought

It is crucial to know how to calculate return on capital employed, since ROCE is a crucial financial ratio. It analyses how effectively a company uses its capital to generate profits. However, it also tends to neglect the time value of money and the risks involved in investments.

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Frequently Asked Questions

1. What is an appropriate ROCE ratio?

There is no industry standard, but when a company achieves a 20% ROCE ratio, it can be considered good.

2. How is an ROCE different from ROE?

A return on capital employed is different from a return on equity (ROE). An ROCE measures a company’s efficiency in using its total capital to generate profits. On the other hand, an ROE determines the efficiency of a company in using shareholders’ equity to generate returns.

3. Is a higher ROCE good?

Yes, a company with a higher ROCE is considered good since it indicates that the company is utilising its capital effectively to generate profits.

4. Is 10% a perfect ROCE?

Whether a 10% ROCE is considered good depends entirely on the sector, the economic environment, and other factors.