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How to Calculate Return on Capital Employed?

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Return on capital employed (ROCE) is one of the most commonly used financial ratios to assess how efficiently a company generates profits from its capital. This key figure indicates how effectively a company uses its capital to achieve earnings before interest and tax (EBIT). ROCE is a key tool used by investors, analysts and management to assess a company`s financial health and profitability.

What is Return on Capital Employed (ROCE)?

ROCE Formula

The formula for calculating ROCE is:

Return on Capital Employed (ROCE) = EBIT / Capital Employed X 100

EBIT (Earnings Before Interest and Tax): This is the company`s operating profit before considering interest expenses and tax. It is often referred to as operating income, which is the profit a company generates from its core business operations.

EBIT = Revenue - COGS (Cost of goods sold) - Operating expenses

Capital Employed: This is the total capital invested in the company`s operations. It can be calculated in different ways, but the most common method is:

Capital employed = Total Assets - Current Liabilities

Step-by-Step Guide to Calculate ROCE

Let`s break down the steps involved in calculating ROCE:

Step 1: Gather Financial Information

To calculate ROCE, you`ll need the following financial data:

EBIT (Earnings Before Interest and Tax): Determine EBIT from the company`s income statement. If EBIT isn`t stated, you can calculate it by adding interest and tax expenses to net income.

Capital Employed: This can be calculated using the company`s balance sheet. Total capital employed includes equity, long-term debt, and other long-term liabilities. It can also be calculated by subtracting current liabilities from total assets.

Step 2: Calculate EBIT

Make sure EBIT represents the company`s operating profit before interest and taxes. If it`s not listed, you can get it like this:

EBIT = Revenue -COGS (Cost of goods sold) - Operating expenses

Step 3: Calculate Capital Employed

Now, plug the values of EBIT and Capital Employed into the ROCE formula:

Return on Capital Employed (ROCE) = EBIT / Capital Employed X 100

This will give you the total capital invested in the company.

Step 4: Apply the Formula

Now, plug the values of EBIT and Capital Employed into the ROCE formula:

Formula:

ROCE = \frac{EBIT}{Capital Employed} X 100

ext{ROCE} = frac{ ext{EBIT}}{ ext{Capital Employed}} imes 100

Using the example data, where EBIT is $2,000,000 and capital employed is $7,000,000:

ext{ROCE} = frac{2,000,000}{7,000,000} imes 100 = 28.57\%

This means the company generates a return of 28.57% on every dollar of capital employed.

Example of ROCE in Action

Let`s say we are evaluating two companies in the same industry: Company A and Company B.

Company A: EBIT = $2,000,000, Capital Employed = $8,000,000
Company B: EBIT = $2,000,000, Capital Employed = $10,000,000

For Company A:

$ext{ROCE} = frac{2,000,000}{8,000,000} imes 100 = 25\%$

For Company B:

$ext{ROCE} = frac{2,000,000}{10,000,000} imes 100 = 20\%$

Although both companies have the same EBIT, Company A has a higher ROCE, indicating it is more efficient in using its capital to generate profits.

Why is ROCE Important?

1. Efficiency Measurement:

ROCE is an important ratio for measuring how efficiently a company is using its capital to generate profits. A high ROCE indicates that a company is effectively using its resources to generate profits.

2. Comparative Analysis:

ROCE is useful for comparing companies in the same industry: if two companies have similar operations, the one with a higher ROCE is generally a more efficient use of capital.

3. Investor Insights:

For investors, ROCE is a key indicator of a company`s profitability and long-term sustainability, and a higher ROCE may indicate that the company is likely to generate higher returns for its shareholders.

4. Business Decision-Making:

Companies can use ROCE to evaluate capital allocation decisions: if the ROCE is low, the company may need to reconsider its use of capital or explore alternatives that may yield higher returns.

How to Interpret ROCE?

High ROCE

A high ROCE indicates that a company is using capital effectively to generate profits, and while there are no universally good or bad ROCE values, a higher ROCE relative to peers is usually considered a positive.

Low ROCE

A low ROCE can indicate that a company is not using capital efficiently, and this can be a warning signal for investors, especially if the ROCE is significantly below the industry average.

Consistency Over Time

It is important to monitor ROCE trends over the long term. When a company achieves a consistently high ROCE, it indicates high operating efficiency and profitability. On the other hand, a declining ROCE could indicate that a company is having trouble managing its capital or is experiencing declining profitability.

Conclusion

ROCE is a valuable financial ratio used to evaluate a company`s ability to generate profits from capital investments. Calculating and analyzing ROCE can provide business owners, investors, and analysts with valuable insight into how well a company is utilizing its resources to generate profits. Note that it is important to compare ROCE to industry standards and consider other financial metrics to get a comprehensive view of a company`s financial health.