Return on Capital Employed (ROCE) : Importance and Limitations | 5paisa (2024)

Introduction

ROCE, also known as Return on Capital Employed is a financial measure used to assess a firm's capital efficiency and profitability. This indicator determines how efficiently a corporation uses its invested capital to maximize wealth. Investors, financial managers, and other stakeholders can analyze a company's performance and determine if it is a good investment by looking at ROCE. It is one of the numerous profitability measures that analysts may employ to assess a company's financial health.

What is ROCE Return on Capital Employed?

ROCE indicates how well a company is generating profits from the total capital employed in its business operations, including both debt and equity financing. When assessing a company's investment prospects, investors frequently use the return on capital employed statistic as their key profitability ratio. This ratio is frequently seen as a useful instrument for assessing a company's investment attractiveness by evaluating the returns produced from the capital invested in its activities.

How to Calculate ROCE

Here’s the formula to calculate ROCE:

ROCE = EBIT/Capital employed

Where,

EBIT = Earnings before interest and tax
Capital employed = Total assets - current liabilities

EBIT: It is also known as operating income. It is computed by deducting the income of an organization from its operational costs, excluding interest and tax costs.

Expenses connected to running a firm, such as salaries and wages, rent, utilities, marketing expenditures, and other related costs, are often included in operating expenses. EBIT illustrates how much profit a business makes from its core activities, excluding the effects of interest and taxes, by subtracting these expenses from revenue.

Capital Employed: Capital Employed is a financial metric used to determine the amount of capital a company has used in its operations. It is similar to Invested Capital used in the ROIC calculation.

A higher ROCE indicates that the company is more efficient in using its capital to generate profits.

Examples of the Capital Employed Formula

Here are two examples illustrating how to calculate ROCE:

Example One:

In 2018, a company had a net operating profit of Rs.20 million, with total assets and total current liabilities of Rs.150 million and Rs.90 million, respectively, according to its annual report.
To calculate the company's ROCE for the year, we can use the following formula:
ROCE = EBIT / (Total Assets - Total Current Liabilities)
ROCE = Rs.20 million / (Rs.150 million - Rs.90 million)
ROCE = 33.33% for 2018.

Example Two:

According to the annual report, a company had an operating income of Rs.70.90 billion in 2018, with total assets and total current liabilities of Rs.365.73 billion and Rs.116.87 billion, respectively, as of September 29, 2018.
To calculate the company's ROCE for the year, we can use the following formula:
ROCE = EBIT / (Total Assets - Total Current Liabilities)
ROCE = Rs.70.90 billion / (Rs.365.73 billion - Rs.116.87 billion)
ROCE = 28.49% for 2018.

ROCE Importance and Limitations

Here are some of the importance and limitations of ROCE:

Importance:

● Helps in evaluating a company's profitability: ROCE helps in evaluating a company's profitability by measuring the amount of profit earned from each unit of capital employed in its operations.

● Indicates a company's efficiency in using its capital: ROCE indicates how efficiently a company is using its capital to generate earnings. A high ROCE indicates that the company is generating more earnings per unit of capital employed, whereas a low ROCE suggests the opposite.

● Useful in comparing companies: ROCE can be used to compare the efficiency of different companies in generating earnings from their capital. This can help investors in identifying potentially profitable investment opportunities.

Limitations:

● Ignores the cost of capital: ROCE does not consider the cost of capital. A company may have a high ROCE, but if its cost of capital is also high, the company may not be generating enough earnings to cover its cost of capital.

● Doesn't account for non-operating items: ROCE doesn't account for non-operating items such as interest income and non-recurring gains or losses. This may lead to a distorted view of a company's profitability.

● Dependent on accounting practices: ROCE is dependent on the accounting practices followed by a company. Different companies may use different accounting methods, which can affect the calculation of ROCE and make it difficult to compare companies.

Conclusion

In conclusion, while ROCE is a useful financial metric for evaluating a company's efficiency in generating earnings from its capital, it is important to consider its limitations and use it in conjunction with other financial metrics for a more comprehensive evaluation.