Return on Capital Employed (ROCE) - A Complete Guide

It is important to carefully examine all the fundamentals and financial metrics of the company before investing. As a smart investor, you must check to take a closer look at various financial metrics including EPS (Earnings Per Share), P/E (Price-to-Earnings) Ratio, P/B (Price-to-Book) Ratio, and D/E (Debt-to-Equity) Ratio, ROCE (Return on Capital Employed) and more. ROCE gives you insights into the efficiency of a company utilizing its capital. It indicates how the company is using its capital to generate profits. Keep reading to learn more about ROCE (Return on Capital Employed), the importance of ROCE, the ROCE formula, and examples of ROCE  in detail.

What is ROCE?

ROCE is a popular financial Ratio used for measuring the efficiency and profitability of a company in terms of its total capital employed. You can identify capital employed by combining equity and debt. It represents the total funds invested by the company to generate profit.

How to calculate ROCE?

You can calculate ROCE by dividing a company’s EBIT (earnings before interest and tax) by its capital employed. To find out capital employed, you must remove total liabilities from the total assets of the company.

ROCE Formula

ROCE= EBIT/Capital Employed

• ROCE includes two components: earnings before interest and tax and capital employed.
•  EBIT - Earnings Before Interest and Tax:  It is determined by deducting revenue from the cost of goods sold and operating expenditures.
• Capital Employed = Total Assets – Current Liabilities: It is determined by deducting total assets from current liabilities.

Example of ROCE

Company ABC, its operating income in 2023 is ₹200 crores. The company has total assets worth ₹400 crores and current liabilities of ₹90 crores. So, the ROCE of the company for 2023 will be calculated as follows-

ROCE= EBIT/Capital Employed x 100

=₹200 crores/( Total Assets-Current Liabilities) x 100

=₹200 crores/(₹400 crores-₹90 crores) x 100

=₹200 crores/₹310 crores x 100

=64.51%

So, Company ABC has an ROCE of 19.35% for 2023.

Let us compare it with another company, Company XYZ, which has an EBIT of ₹250 crores. With an EBIT of ₹250 crores, Company XYZ seems to have a better investment than Company ABC which has an EBIT of ₹200 crores. However, let us find out more by calculating the ROCE of Company XYZ:

Company B has assets worth ₹700 crores and current liabilities of ₹80 crores. Its ROCE will be as follows-

ROCE= EBIT/Capital Employed x 100

=₹250 crores/(₹700 crores - ₹80 crores) x 100

=₹250 crores/₹610 crores x 100

=40.32%

So, concerning ROCE, Company ABC is a better investment as it has an ROCE of 64.51% while Company XYZ has an ROCE of 40.32%.

Importance of ROCE

Return on Investment Employed (ROCE) is beneficial for investors while making an investment decision to understand a company's ability to make higher profits. The following are the importance of ROCE:

• Easy to compare:  ROCE can be used for comparing firms in the same sector.
• Understanding strengths and weaknesses:  both investors and businesses can use ROCE to measure performance and identify strengths and weaknesses. This allows the business to improve performance.
• Financial efficiency: ROCE helps in understanding the financial efficiency of the company. It is calculated by deducting the amount of capital needed to achieve a set profitability.
• Comparing capital-intensive firms: ROCE is best for comparing capital-intensive companies with high capital demand for operations. For any potential investors, a company with high capital investment and profit can be a good investment option.
• Returns: With ROCE, you can determine companies that spend capital effectively to generate high profits. Also, investors use the ROCE ratio to compare different firms in the market.

Limitation of ROCE

While ROCE holds importance for measuring financial performance. It has certain limitations such as:

• Limited to the same sector: You can use ROCE to compare the financial performance of two companies in the sector. While it is not considered precise for comparing companies in different industries.        
• Ineffective: It is advised to use the ROCE ratio along with other financial measures to get more insights and make investment decisions.
• Untapped Cash Reserves: Companies with underutilized cash reserves will have a reduced ROCE, which might influence the actual result and the overall choice. ROCE is not the appropriate metric for businesses with sizable, untapped cash reserves.
• Capture changes across time: based on the annual market performance of the company, ROCE changes from year to year. While comparing different companies, it is vital to consider how ROCE changed over time.

ROCE vs ROE

Below is the difference between ROCE and ROE