Assessing the profitability of a business is one of the things that not only business owners but also potential investors and stakeholders take a deep interest in. ROCE is one of many financial ratios that determines returns on capital employed and companies' ability to generate profits for each dollar of capital invested.
What is ROCE?
ROCE (return on capital employed) is a profitability ratio that calculates how much profit your business will generate from the capital employed. It measures how efficiently you manage your capital. So, to calculate ROCE you need to have two components already calculated, EBIT and capital employed.
ROCE calculates how many cents you get per $1 of capital employed or the percentage of returns. In this way, it tells you how efficiently you are managing your capital.
How is ROCE calculated?
You can calculate return on capital employed by dividing net operating profit (EBIT) by capital employed.
EBIT(earnings before interest and tax), also referred to a net operating profit can be calculated from the income statement of a company. EBIT is the net income before you pay your tax and interest expense Though EBIT is used interchangeably with net operating profit, EBIT is not always the same as operating profit.
Net operating profit or operating income refers to the earnings from the core operations of a business and excludes all non-operating expenses too. Whereas EBIT entails all the earnings that can be from returns on other investments like a stock investment.
Capital employed refers to the funds employed by the business to generate profit. It is the part of the capital that generates profits for a business. It can be calculated by subtracting current liabilities from total assets.
Assets are the resources that a business owns. We can see a detailed breakdown of the assets of a company on its balance sheet.
Equity is shareholder’s money. If a business has been operating for years there may be cash surpluses and reserves that accumulate into equity. So, if we break down the equity, it includes shareholder’s equity and retained earnings..
Liabilities are accounts payable and can be current or non-current. Current liabilities are to be paid within one year and usually include payments to suppliers and short-term debt. Non-current liabilities usually include long-term debt. We can see a detailed breakdown of the liabilities of a company on its balance sheet.
Example of return on capital employed calculation
Assume, a company X earned an EBIT of $800,000 in a year. Capital employed, equity plus non-current liabilities, of the company in the same period was $400,000. Returns on Capital Employed for that year can be calculated by the following equation
ROCE = EBIT / Equity + Non-current liabilities
Putting the values, we will get that ROCE is 20 cents per $1 or 20%.
What does ROCE tell you?
A business raises capital through investors and lenders. Investors’ money is equity and lenders provide a business with debt.
Both investors and lenders take a deep interest in ROCE and other profitability ratios before they pledge to release any funds. A steady and high ROCE value puts you ahead of your competitors.
Calculating ROCE as a founder lets you know the returns that you can promise to your strategic partners, lenders, and investors. You can tickle their fancy with a rapid and accurate financial forecast that includes ROCE and other profitability ratios.
Some other examples of profitabilty ratios for assessing financial performance are ROIC (return on invested capital), ROI (Return on investment), and ROE (return on equity).
What is a good ROCE ratio?
There are no standards, to be frank. But a higher ROCE indicates that the company is adept at generating profit for every dollar invested . The lower the ROCE, the lower returns on capital employed. However, in came cases lower ROCE may imply more cash in hand which proves to be a good thing to face an economic crunch.
Another thing to consider is to compare the return on capital employed ratio for companies within the same industry. Some industries aren’t that capital-intensive and may have higher ratio. An average ROCE for a SaaS company will not be the same as an average ROCE for a restaurant.
ROCE vs. ROE
Besides a company's ROCE, ROE (return on equity) is another metric for analyzing profitability.
We calculate ROE by dividing net income by total equity. The equation for the calculation of ROE is
ROE = Net Income / Total Equity
Net income is what we get after subtracting expenses from gross profit. And equity is the sum of equity capital share, cash surpluses and reserves, and preferred equity. Net income is the bottom line in the income statement of a company. Meanwhile, equity is accounted for on a balance sheet of a company.
So, the question is why the investors and lenders go for ROCE when one has already calculated ROE.
ROE may miss some parts of the picture as it doesn’t factor debts and loans. ROCE considers not only equity but also other non-current liabilities and is better to assess a company's profitability .