Return on Capital Employed is also known as ROCE in short form. It’s one of the widely used financial statistics that analyze the profitability and capital efficiency of the concerned company. Using this statistical technique, investors can understand how easily and effortlessly the company can generate profit from the employed capital. This tool is mostly used by investors, fund managers, stakeholders, and traders, who keep looking for great opportunities in the stock market.
What is ROCE?
ROCE, or Return on Capital Employed, is a long-term profitability ratio used by stock traders, investors, financial institutions, and fund managers. This ratio indicates the effectiveness of the asset performance in the long run. Therefore, it can be considered to understand how long the company can survive in the competitive arena.
When users calculate ROCE, they must know that the ROCE of the concerned company should be higher than the cost of employed capital. However, if you are an investor, you must consider ROCE over Return on Equity (ROE). It is because ROE only checks the profitability of the shareholder’s equity. At the same time, ROCE considers equity and debt to give sound insight into the company’s financial strength.
The Formula of ROCE
You can use the below-mentioned formula to calculate ROCE.
Return on Capital Employed (ROCE) = EBIT/Capital Employed
- EBIT stands for Earning Before Interest and Tax, and it’s the profit that includes expenses excluding interest and tax. All in all, it shows the company’s total income before any expense deduction, and you can see it in the P&L account of the company.
- Capital Employed can be defined as the company’s total assets minus current liabilities ( Total Assets – Current Liabilities). Or it can be explained as fixed asset plus working capital (Fixed Assets + Working Capital). This metric shows the total invested equity in the company. In short, working capital is the sum of the company’s equity and debt.
How do We Calculate ROCE?
In the above section, you learned the formula of ROCE; let’s understand how you can use it to calculate it from the available data of the respective company.
Let’s assume company XYZ Ltd has an EBIT of Rs 200 crore in a financial year. In contrast, BTY Ltd has an EBIT of Rs 180 crore in the same financial year. Based on EBIT, company XYZ Ltd may sound better and more profitable. But to get accurate insight, we need to know their ROCE before making any investment decision. So, let’s suppose company XYZ Ltd has capital employed of Rs 800 crore and company BTY Ltd has capital employed of Rs 600 crore.
ROCE (for company XYZ Ltd) = 200/800 = 0.25
ROCE (for company BTY Ltd) = 180/600 = 0.30
For our ROCE calculator for both companies, it’s clear that BTY Ltd has a better investment than XYZ Ltd.
Let’s discuss a second approach, where debt and equity are given.
Suppose ABC Ltd has total equity of Rs 600 crore and debt capital of Rs 400 crore. And its EBIT is Rs 190 crore; let’s find the ROCE of ABC Ltd.
ROCE (for company ABC Ltd) = EBIT/ Total Equity + Total Debt = 190/600 + 400 = 190/1000= 0.19 or 19%
Why is ROCE Important for Traders?
ROCE is one of the important metrics that most traders and fund managers use. Below are some points that show the importance of ROCE for traders.
- Return on Capital Employed helps to analyze the performance of the capital-intensive business, including petroleum refineries and car manufacturers. These companies have huge capital investments. Hence before trading with their share, it’s essential to know vital information about their capital efficiency.
- It includes debt and other liabilities, so it’s a better metric to determine the company’s profitability than ROE. For example, a huge portion of capital can be financed using debt, which will increase the ROE, but it’s not efficient to measure profitability.
- This ratio can be used to compare the performance of two or more companies in the same industry. Generally, investors consider a company to have a higher ROCE ratio than other companies in the same industry.
- The higher ROCE value indicates better performance of a company than its rivals.
- Using ROCE, along with ROE, ROA, and other performance measures, investors can make better investment decisions.
Limitations of Using ROCE?
There are certain limitations in using ROCE for checking a company’s performance; look at the below to know these points.
- ROCE does not show accurate insight when comparing two companies from different industries.
- ROCE is not a good profitability ratio for businesses having unused cash reserves, as their ROCE will be lower.
- This ratio calculates the value based on the book value of the assets. Although, the assets keep depreciating with time, and ROCE increases even though there is constant cash flow. Therefore, the businesses in the market for years will have higher ROCE than the newly established companies, even though these companies are performing better.
- The value of ROCE keeps changing yearly; hence, one will be required to consider such a metric for years to get an accurate insight into the performance of companies.
What Kind of Information does ROCE Provide to Traders and Investors?
ROCE helps traders and investors understand how well the company uses its employed capital. Using this metric, they can understand which company is performing better even after having similar earnings and profit margins and belonging to the same industry. This ratio can also be used as a fundamental analysis ratio along with ROE and ROA to gather deeper insights into a company’s overall performance.
What is a Good Return on Capital Employed Ratio?
Generally speaking, there is not any fixed parameter for ROCE. However, the higher ROCE value shows the better performance and productiveness of the company. But this measure would not be useful if the company has so much cash in hand, as it would mean the capital has not been properly employed or used.
Conclusion
ROCE is a widely used measure by traders, investors, and fund managers. They mainly use this ratio for capital-intensive businesses to know their performance and capital efficiency. However, there is no fixed parameter for ROCE, but most investors prefer investing in a company if its ROCE has been over 15% in the last five years. You can consider this standard rate and use another measure to get more insights before making any investment decision.