What is Return on Capital Employed (ROCE)?

ROCE is a financial ratio used to measure the profitability of a company in relation to the capital it has invested in its business. It shows how effectively a company is using its capital to generate profits. A higher ROCE indicates a more efficient use of capital, which is generally a positive sign for investors. In simple terms, ROCE tells you how well a company is making money from the funds invested in it.

How to Calculate ROCE – ROCE Formula

To calculate Return on Capital Employed (ROCE), you need two important figures: Net Operating Profit and Capital Employed.

Here’s the formula:

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

1. Net Operating Profit is the profit made from the company’s core business operations. It excludes any extra income like investments or non-operating gains. This profit is typically shown on the company’s income statement.
2. Capital Employed is the total amount of money that has been invested in the company. To calculate it, subtract current liabilities (short-term debts or bills) from total assets (what the company owns). You can also add long-term debt and equity together to find this number.

If a company has a Net Operating Profit of ₹40,00,000 and Capital Employed of ₹2,00,00,000, the calculation will be:

ROCE = (₹40,00,000 / ₹2,00,00,000) × 100 = 20%

This means the company is earning a return of 20% on the capital invested in its business.

The higher the ROCE, the better the company is at generating profits with the capital it has. It helps investors understand if the company is making good use of the money invested in its operations.

Example of the Capital Employed Formula

Let’s look at an example to understand how to use the capital employed formula.

Imagine a company, ABC Ltd., which has the following details:

• Total Assets: ₹50,00,000
• Current Liabilities (short-term debts): ₹10,00,000

To find the Capital Employed, we subtract the current liabilities from the total assets:

Capital Employed = Total Assets – Current Liabilities

So,

Capital Employed = ₹50,00,000 – ₹10,00,000 = ₹40,00,000

Next, ABC Ltd. reports a Net Operating Profit of ₹8,00,000 for the year.

Now, using the formula for ROCE:

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

ROCE = (₹8,00,000 / ₹40,00,000) × 100 = 20%

This means ABC Ltd. is earning a return of 20% on the capital employed in its business.

Importance of ROCE

ROCE (Return on Capital Employed) is an essential financial metric that provides insights into a company’s efficiency and profitability. Here’s why it matters:

1. Measures Business Efficiency

ROCE is a valuable tool to measure how efficiently a company uses its capital to generate profits. By comparing the profit earned with the capital employed, ROCE shows how well a company is utilising its investments in operations.

2. Helps Investors Make Informed Decisions

Investors look for companies with high ROCE because it indicates strong profit generation from the capital used. A higher ROCE generally means the company is efficiently using its resources, which can lead to better returns for investors.

3. Assesses Long-Term Profitability

Unlike other profitability ratios, ROCE is particularly useful for assessing long-term profitability. It highlights a company’s ability to generate profit over time without relying on external factors, like market conditions. Companies with consistently high ROCEs are often seen as more stable.

4. Useful for Comparing Companies

ROCE allows investors to compare the performance of different companies, even in different industries. It provides a standard measure to evaluate how effectively capital is being employed, helping to identify which companies are better at generating profits from their investments.

5. Indicates Business Growth Potential

A rising ROCE over time suggests that a company is growing efficiently, using its capital wisely to expand its business. This can be an important sign of future growth and increased profitability.

Also Read: What is Rolling Return in Mutual Fund: Calculation and Analysis

Limitations of Return on Capital Employed (ROCE) 

While ROCE is a useful metric, it has its limitations that investors should keep in mind. Here are some key points to consider:

• Doesn’t Reflect Short-Term Performance: ROCE focuses on long-term profitability, which may not capture immediate financial issues or short-term performance dips.
• Not Suitable for All Industries: Some industries require more capital investment than others. Comparing ROCE across different sectors might not provide an accurate picture of performance.
• Ignores Capital Structure Changes: ROCE doesn’t consider changes in a company’s capital structure, such as increasing debt, which could affect financial risk and profitability.
• Excludes Non-Operating Income: ROCE focuses only on operating profits and doesn’t factor in non-operating income or expenses, potentially overlooking important financial aspects.
• Can Be Manipulated: Companies can manipulate ROCE by altering financial statements, such as underreporting liabilities or overstating profits, which could mislead investors.

Conclusion

In conclusion, Return on Capital Employed (ROCE) is a key indicator of a company’s efficiency in utilizing its capital to generate profits. It helps investors assess the company’s performance, make comparisons, and determine investment potential. However, it’s important to remember that ROCE has its limitations, especially when comparing companies across different industries or dealing with companies with changing capital structures. Therefore, while ROCE is helpful, it should be used with other financial metrics for a more comprehensive analysis.