What Is Return on Capital Employed: Formula and How to Calculate It

Small businesses and large corporations both use a range of different ratios and metrics to make financial analysis and determine their profitability. This allows for informed decision-making, growth through external investments, and more.

One of the key metrics that demonstrates how efficiently a company is utilising its capital to accumulate profit is the return on capital employed or ROCE.

In the following sections, we explain what return on capital employed is, how it’s calculated, why it matters, and more. 

What Is Return on Capital Employed (ROCE)?

Return on Capital Employed (ROCE) is a vital profitability ratio that measures a company’s efficiency in deploying capital to generate profits. 

As a metric that gives insight into the business’s ability to generate returns on its invested capital, ROCE is an essential factor for investors and analysts interested in the financial performance of different companies.

For companies, this measurement is key for evaluating long-term profitability. It also enables comparisons between companies operating in the same industry or niche. 

The Return On Capital Employed Formula

Return on capital employed can easily be worked out by using the ROCE formula.

The standard formula for return on capital employed is as follows: 

ROCE = Operating Profit (EBIT) / Capital Employed × 100

In order to calculate ROCE, you’ll need to identify the company’s average capital employed and Earnings Before Interest and Tax. 

Operating profit or EBIT measures a company’s profit from operations before financing costs. 

On the other hand, capital employed represents the total capital invested in the business. It’s simply the capital investment required for the company to function. You can calculate it by subtracting current liabilities from total assets. Keep in mind that capital employed is often confused with invested capital or capital investment. However, these terms are different in nature.

While invested capital is the capital flowing through a business, capital employed is the available capital that a company has. In that sense, capital employed is more comprehensive and analyses the total equity and long-term financing minus short-term debt liabilities. 

How to Calculate Return on Capital Employed (ROCE)

Return on capital employed demonstrates how much income is generated for each dollar invested in capital.

But how can you calculate this metric accurately?

All of the information that you’ll need for the ROCE calculation can be found on the company’s balance sheet. 

Let’s go through the step-by-step process of calculating return on capital employed:

• Step 1: Identify operating profit – Find Earnings Before Interest and Tax from the company’s income statement and take away interest expenses and taxes, focusing purely on operational performance.
  
• Step 2: Calculate capital employed – The capital employed calculation can take place via the capital employed formula: total assets – current liabilities. Total assets include fixed assets (property, machinery, others) and current assets (inventory, accounts receivable), while current liabilities are short-term financial obligations.
  
• Step 3: Apply the ROCE formula – Insert the values into the ROCE formula: Operating Profit (EBIT / Capital Employed × 100
  
• Step 4: Interpret the result – A higher ROCE indicates greater efficiency in generating returns from capital employed. You can compare your results against other companies in the same sector. 

Following these steps, you’ll be able to make an accurate assessment of your company’s return on capital employed. 

Example Calculation of ROCE

Let’s say a clothing company’s liabilities (accounts payable, income tax, and others) are worth £50,000, while its total assets are equal to £ 200,000.

By subtracting the liabilities (£50,000) from the assets (£200,000), we can find the capital employed (£150,000). 

Meanwhile, the business’s annual revenue is £180,000, and its costs are £130,000. By working out the calculations, we can see that EBIT in this case is equal to £50,000.

All we have to do now is divide the EBIT (£50,000) by the capital employed (£150,000) to find the company’s return on capital employed – 0.33 or 33%. 

What is a Good ROCE?

The general rule is that a good ROCE value is higher than the company’s weighted average cost of capital (WACC). If a company’s ROCE is below the weighted average cost of its capital, this means that it’s wasting capital. 

Naturally, a higher return on capital employed signals that the implemented capital employment strategies are showing positive results. In other words, the higher the ROCE, the more profit a business is generating. 

Why ROCE Is Important for Businesses

A business’s ROCE can reveal a lot about the financial health of the company and can create numerous opportunities. This metric’s importance for business is directly tied to several ROCE advantages worth mentioning. 

These are:

• Assessing financial health – Via the ROCE metric, business owners and leaders can identify how well they’re using capital to make profits. It can also be used to assess whether the company is achieving an acceptable return for investors and creditors.
  
• Measuring operational efficiency – Return on capital employed shows how efficiently a company is using both fixed assets and working capital, making it possible to spot weak areas that can be optimised.
  
• Comparing companies – Investors and analysts use ROCE to compare companies in capital-intensive industries like manufacturing or utilities to make better decisions. A company with a higher ROCE typically outperforms its competitors in profitability.
  
• Attracting potential investors – A strong ROCE signals efficient use of capital and can attract investors looking for sustainable returns.

Considering all of the above-mentioned factors, ROCE cannot be underestimated or neglected, no matter how small or large your business is. 

How to Improve Return on Capital Employed

One of the ways to boost return on capital employed is by increasing operating profit. You can achieve this by reducing operating expenses to secure better margins. Concentrate on generating higher sales revenue while keeping costs down. 

Another avenue to explore is optimising capital allocation. Rather than making investments in low-return assets, focus your efforts on appealing and rewarding investment opportunities with certain gains. If possible, you can also sell or repurpose any existing assets that you’re not fully utilising to get access to more capital. 

Improving cash flow management can also dramatically improve ROCE. To do so, ensure faster customer payments by equipping every one of your stores with a last generation business card machine and enabling quick, safe, and reliable payment solutions if you sell online. This can make payments easier, thus increasing sales volume and speeding up cash flow. 

Common Reasons for a Decline in ROCE

Even if you’re putting in place different activities to maximise performance, your ROCE can still be dropping.

So what are the reasons for a decrease in return on capital employed?

Here are a few common examples:

• Lower operating profit – A decline in sales revenue or an increase in operating costs can negatively impact EBIT, causing an overall drop in ROCE.
  
• Increased capital employed – Investing heavily in fixed assets or taking on long-term debts increases capital employed without an immediate increase in profits, therefore affecting return on capital employed.
  
• Inefficient resource management – Poor inventory management, idle assets, or slow accounts receivable turnover can also reduce efficiency.

Being aware of these reasons and strategically avoiding them can help you keep your ROCE metric high, ensuring your business is financially healthy and appealing for investors.

Limitations of ROCE

Just like any other financial ratio, ROCE goes hand in hand with several limitations that must be addressed.

First, it ignores short-term financial challenges and only prioritises long-term efficiency. This may cause discrepancies in the ability to analyse and assess the bigger picture accurately. 

Second, for companies positioned in capital-intensive industries, the ROCE is likely to be significantly lower, especially when compared to those in service-based sectors. This is due to the fact that businesses in capital-intensive industries usually have a lot of fixed assets. Therefore, making comparisons between organisations in different industries is not very reliable. 

Finally, it’s important to consider depreciation. Asset depreciation also reduces EBIT, which can negatively impact ROCE results, even if overall operations are efficient. 

Understanding and Calculating ROCE

Return on capital employed is a critical financial metric that makes it possible to evaluate how effectively companies use capital to accumulate profits. As a representation of operational efficiency, it’s vital for business leaders and investors.

No matter how small or large the business, monitoring ROCE regularly can help make data-backed decisions, attract funding, and ensure long-term growth. 

Frequently Asked Questions