Learn how to increase the return on capital employed with CalcoPolis.
Table of Contents
- What does return on capital employed mean?
- How to calculate return on capital employed?
- Return on Capital Employed formula
- Capital Employed
- Return on Average Capital Employed (ROACE)
- When to use a Return on Capital Employed calculator?
- How to use ROCE to calculate efficiency of capital employed?
- How to use ROCE for company valuation?
- How to use ROCE to determine if a company could receive additional funds?
- How to use ROCE to benchmark companies?
- ROCE is not an universal metric
- ROCE undermines long term investments
- Startups usually have low ROCE
- What is a good ROCE ratio?
- Example ROCE calculation
- Alternative calculators
What does return on capital employed mean?
ROCE is a business indicator that measures how well a company generates profit from its working capital. In other work this metric tells how profitable a company is.
There are many similar financial metrics, some of them differ slightly from ROCE and are oftentimes misunderstood. That’s why in this article we will explain all the nuances and differences between ROCE and its alternatives such as Return on Invested Capital, Return on Assets and Return on Equity.
- ROCE gives information on how much profits a company generates using its capital.
- Capital Employed represents the company's total assets minus short term liabilities.
- ROCE is a metric very similar to ROIC.
- ROCE should be higher than the Weighted Average Costs of Capital in order to be considered as a good value generator.
How to calculate return on capital employed?
Return on Capital Employed formula
ROCE = (EBIT / Capital_Employed) * 100%
Earnings Before Interest and Taxes, also known as operating income, represents how much a company earns on its regular business before interests and taxes are deducted.
Simply it’s a total capital put to work by the company, it can be calculated by subtracting current liabilities from total assets the company has.
Capital Employed = total_assets - current_liabilities
From the accounting perspective the formula above is an equivalent of shareholders’ equity and long-term debts.
Capital Employed = shareholders’ equity + long-term debts
Return on Average Capital Employed (ROACE)
Some investors prefer a slightly different approach for determining the value of ROCE and use average capital employed, which is the arithmetic average of capital employed at the beginning and end of the analyzed period.
Average Capital Employed = (Starting Capital + Ending Capital) / 2
And now we can derive the ROACE formula:
ROACE = (EBIT / Average Capital Employed) * 100%
Key takeaways from the equations
- ROCE can be increased either by increase of EBIT
- High long-term debts can reduce ROCE ratio if the money is not used efficiently
When to use a Return on Capital Employed calculator?
Return on Capital Employed is an advanced financial metric and if calculated correctly can provide a good overview of a company's efficiency in turning invested capital into profits.
How to use ROCE to calculate efficiency of capital employed?
ROCE is a good metric of company efficiency in utilizing available resources for generating profits. In order to interpret its value correctly it’s important to know that since ROCE ignores short term liabilities, it is meant for analyzing the prospects of long term financing.
How to use ROCE for company valuation?
Calculating ROCE is an important component of fundamental analysis of the enterprise, but not the only one. Since there are many factors that have an impact on a company's profitability and prospects of further growth, other metrics should be applied as well for determining the real value of the business.
How to use ROCE to determine if a company could receive additional funds?
There are two main methods of acquiring additional financing for the company: rising debt or selling shares. Although each option has its own pros and cons. There is one fundamental question that needs to be asked before increasing company funds: “will the company be able to create more value with more funding at the extra cost?”
This could be determined by comparing ROCE to Weighted Average Cost of Capital (WACC). If ROCE is higher than WACC it means that extra funds could be turned into profits.
How to use ROCE to benchmark companies?
Return on Capital Employed can be applied for comparison of the companies. Especially to determine now well they utilize the available capital.
However it shouldn’t be used for analyzing financial performance of the companies from different industries. Since the structure of the businesses is radically different.
The best approach to this task is to compare their ROCE with the benchmark value for the industry.
Limitations of ROCE
Below we discuss situations when you should be cautious about the ROCE indicator.
ROCE is not an universal metric
By performing ROCE calculation you can find out useful information about a company, trends and prospects for raising new funding, although it doesn’t provide detailed information about individual components of the enterprise.
ROCE undermines long term investments
Similarly as in the case of ROIC, this financial ratio ignores the investments that are yet to bring profits. So if the company is involved with long term projects that are about to generate income many years into the future. ROIC calculation will not reveal the full potential of the company.
Startups usually have low ROCE
For the similar reasons as before, recently founded companies have low or even negative ROCE ratios. Investments need time before they start to bring profits and analyzing this metric at first years of the business is not always the right approach.
What is a good ROCE ratio?
There is no simple answer for that question, since much depends on the market segment. The best way of determining what is a good ROCE value is to check benchmarks for the entire industry and compare with a company's ROCE.
Since the intent for ROCE metric is to analyze efficiency in utilized available capital by comparing ROCE with weighted average cost of capital WACC, investors can tell if ROCE is high enough to justify further investments into the company.
Example ROCE calculation
Calculation of ROCE is fairly easy, since all the information needed is available in the balance sheet and income statement. The only thing you need to do is to substitute the values into the ROCE equation.
Let’s calculate ROCE for Apple Inc. (AAPL). In fiscal year 2021 Apple generated EBIT $111,852,000,000.
The company has average capital employed equal $222,000,000,000, so return on capital employed can be calculated as follows:
ROCE = (EBIT / Avg. Capital Employed) * 100% = $111,852,000,000 / $222,000,000,000 * 100% = 50,4%