Return on capital employed

Return on capital employed

Return on capital employed, often known as ROCE, is a profitability ratio that compares a company’s net operating profit to the amount of capital it has used. This ratio is used to determine how well a business can make profits from the resources it has available. To put it another way, return on capital employed demonstrates to investors how many dollars in profits are generated by each dollar of capital that is put to use.

The return on capital employed, or ROCE, is considered a profitability measure for the long term since it demonstrates how well assets are functioning when long-term financing is taken into account. When determining the viability of a business, return on capital employed, or ROCE, is a more helpful ratio than return on equity.

This ratio is determined by calculating operational profit in comparison to the amount of capital that is put to use. The term “earnings before interest and taxes” (EBIT) is often used interchangeably with “net operating profit.” It is common practise to present EBIT on the income statement since this metric reveals the profits that were earned by the company’s activities. In the event that it is necessary to do so, EBIT may be computed by putting back in interest and taxes to net income.

Because it may be used to refer to a wide variety of financial statistics, “capital employed” is a word that can be considered to be very confusing. The term “capital employed” often refers to the difference between a company’s total assets and its total current liabilities. One further way to think about this is as the shareholders’ equity subtracted from the long-term obligations. Both add up to the same total value.

Formula

Return on capital employed formula is calculated by dividing net operating profit or EBIT by the employed capital.

Return on Capital Employed = Net Operating Profit / Employed Capital

If employed capital is not given in a problem or in the financial statement notes, you can calculate it by subtracting current liabilities from total assets. In this case the ROCE formula would look like this:

Return on Capital Employed = Net Operating Profit / Total Assets – Current Liabilities

Where:

• Fixed Assets, also known as capital assets, are assets that are purchased for long-term use and are vital to the operations of the company. Examples are property, plant, and equipment (PP&E).
• Working Capital is the capital available for daily operations and is calculated as current assets minus current liabilities.

It isn’t uncommon for investors to use averages instead of year-end figures for this ratio, but it isn’t necessary.

Analysis

The return on capital employed ratio shows how much profit each dollar of employed capital generates. Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated by each dollar of capital employed.

For instance, a return of .2 indicates that for every dollar invested in capital employed, the company made 20 cents of profits.