How Useful Is ROCE as an Indicator of a Company's Performance?

Return on capital employed (ROCE) is a good baseline measure of a company’s performance. ROCE is a financial ratio that shows if a company is doing a good job of generating profits from its capital. Companies have various financial resources they use to build and grow their businesses.

This capital creates wealth through investment and can include such things as a company’s marketable securities, production machinery, land, software, patents, and brand names.

How a company chooses to allocate its capital assets can directly impact its performance. In many cases, it can mean the difference between the company generating a positive financial return or losing money. ROCE is a valuable tool for measuring this.

Key Takeaways

Return on capital employed (ROCE) is a financial ratio companies use to gauge their performance.
ROCE is an indicator of a company’s efficiency because it measures the company’s profitability after factoring in the capital used to achieve that profitability.
The formula for ROCE is earnings before interest and taxes (EBIT) divided by the capital employed.
Investors and analysts often use ROCE as a useful tool when researching a company as a possible investment.
ROCE is particularly effective in comparing companies in capital-intensive industries, such as oil and gas companies.

Understanding Return on Capital Employed (ROCE)

While companies use ROCE as a useful metric to gauge their performance, they aren’t the only ones who can benefit from it. Analysts, shareholders, and prospective investors all use ROCE as a reliable measure of corporate performance when analyzing a company for investment.

ROCE is especially useful when comparing businesses within the same industry. It is best employed in conjunction with other performance measures rather than looked at in isolation.

ROCE is one of several profitability ratios used to evaluate a company’s performance. It is designed to show how efficiently a company makes use of its available capital by looking at the net profit generated in relation to every dollar of capital utilized by the company.

In addition to ROCE, companies may also review other key return ratios when analyzing their performance, such as return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC).

Formula of ROCE

The formula used to calculate ROCE is as follows:

$begin{aligned} &text{ROCE} = frac{ text{EBIT} }{ text{Capital Employed} }\ &textbf{where:}\ &text{ROCE} = text{Return on capital employed}\ &text{EBIT} = text{Earnings before interest and tax}\ end{aligned}$

You can find a company’s earnings before interest and taxes (EBIT) on its income statement. Some analysts use net profit rather than EBIT to do the calculation. You can calculate capital employed from a company’s balance sheet.

What ROCE Can Tell You

ROCE is a useful measure of financial efficiency since it measures profitability after factoring in the amount of capital used to create that level of profitability. Comparing ROCE to basic profit margin calculations can show the value of looking at ROCE.

As a general rule, to indicate a company makes reasonably efficient use of capital, the ROCE should be equal to at least twice current interest rates.

For example, consider two companies, one with a 10% profit margin and the other with a 15% profit margin. The second company appears to be performing better; however, if the second company uses twice as much capital to generate its profit, it is actually a less financially efficient company because it is not making maximum use of its revenues.

A higher ROCE shows a higher percentage of the company’s value can ultimately be returned as profit to stockholders.

Is Return on Investment (ROI) the Same as Return on Capital Employed (ROCE)?

Both ROI and ROCE are financial metrics that determine how well a company utilizes its capital for operations and growth. ROCE is primarily used when comparing companies within the same industry, whereas ROI can be used with more flexibility. ROCE takes in a specific time period, whereas ROI does not. ROCE primarily looks at how capital is utilized within a company while ROI looks at the returns of an investment.

What Is the Difference Between Capital Employed and Invested Capital?

Invested capital is the level of capital that is flowing through a business. Capital employed is the total capital that a firm has. Capital employed is a more comprehensive number than invested capital; capital employed looks at the total equity and debt financing minus short-term liabilities. Invested capital aims to calculate the return of a business in relation to the capital the business is currently using.

How Do I Calculate Return on Capital Employed (ROCE)?

ROCE can be calculated by dividing earnings before interest and taxes (EBIT) by capital employed. It can also be calculated by dividing EBIT by the difference between total assets and current liabilities.

The Bottom Line

ROCE is a useful metric of financial performance and has been shown to be particularly helpful in comparisons between companies engaged in capital-intensive industry sectors. It has gained a strong reputation as a benchmark financial tool for evaluating oil and gas companies.

However, no performance metric is perfect, and ROCE is most effectively used with other measures, such as return on equity (ROE). ROCE is not the best evaluation for companies with large, unused cash reserves.

This article was originally published by Investopedia.com. Read the original article here.