What is Return on Capital Employed?
Return on capital employed is a basic investment appraisal technique which helps to analyze the efficient utilization of capital invested. In other words, it can be explained as how well a company generates profits for invested capital in the business. Return on Capital Employed is a technique frequently used by investors and shareholders if the company is profitable. Now you know the definition, lets dive into how to calculate Return on Capital Employed.
How To calculate Return On Capital Employed ROCE
Where: Capital Employed = Total Assets – Current Liabilities.
Concept of Return on Capital Employed
Basically, return on capital employed signifies generation of operating profits for Certain Capital invested in business. In Short, It is the amount of profit generated for every dollar invested in the business. The higher the ROCE, the better Which doesn’t mean irregular numbers. A good investor always looks for consistent growth in the ROCE year on year.
An investor cannot decide solely based on ROCE for a company its best to calculate other profitability ratios’ such as return on equity, return on assets, and compare with peer companies in same industry.
Why is ROCE Important?
ROCE plays a major role in investigating profitability of a company. Below are some reasons.
- It shows the company’s potential to generate profits and how efficiently the company is generating profits with invested capital.
- It’s easy to compare with the peer companies, where higher ROCE represents better usage, utilization of capital.
- Maintenance of consistency in ROCE represents proper utilization of the capital Which builds investors’ confidence.
- Calculation of ROCE helps in capital allocation based on the profitability of the project. It helps In The investigation of the project having higher returns and whichever needs improvement.
- If a company has a consistent higher ROCE for a long period of time, which indicates the company has been utilizing its resources properly.
Why ROCE is Compared with in the Same Industry?
There are various reasons for this, for example, different industries have different risk, return and capital requirements. Comparing companies among same industries gives you a fair and reliable stat of performance.
Companies in the same industry will have same kind of market conditions and problems, so it gives a meaning full comparison. If a companies ROCE is weaker than other, this signifies there might be a problem in how they are utilizing the capital and resources.
Advantages
- Capital intensive industries are the most beneficial by using ROCE as they require high capital such as manufacturing, because it measures how the companies are converting huge capitals into profits or losses.
- ROCE can be used to comparing efficiency of capital utilization among the competitors and history of same company.
- Calculating return on capital employed will help in investment decision of projects and business. Higher ROCE represents greater value in the investment.
- This gives you an overall picture on capital utilized to generate profits by using equity and debt.
Disadvantages
- ROCE calculation ignores future growth prospects as it is a historical performance measure.
- Following different accounting practices may give different results in ROCE calculation for example how the company calculates depreciation.
- It is difficult to compare when companies have a different capital structure because ROCE does not recognize capital structure either debt or equity. Companies with high gearing may have higher return on capital employed.
- Intangible assets play a significant role where these are ignored by the roce. In addition it does not consider cost of capital which can reduce shareholders wealth if cost of capital is higher than roce.
How can Companies Improve ROCE?
Companies can improve ROCE either by improving their operating profits or better utilization of capital. By reducing costs, increasing sales the operating profits can be improved. Where it comes to the capital employed you need to look at various aspects such as working capital management, investment projects, capital structure and management productivity.
Example of Return on Capital Employed
In this article I have taken reliance as an example to show the readers how to calculate ROCE of a company.
Now lets divide this operating profit with Capital employed calculated above which should give you Return on Capital Employed in percentage.
