What it means
The measure was designed to fix two distortions in conventional return figures. Depreciation policy reduces both reported profit and reported asset values, which can make a company with heavily depreciated equipment look far more profitable than it really is.
CROCI addresses this by using a cash-based earnings figure, typically EBITDA less cash tax, over gross capital invested, which adds accumulated depreciation back to fixed assets. The result is a return on the full amount of money that has been committed to the business over its life.
It matters most when comparing companies with very different asset ages or accounting policies. A twenty-year-old factory almost fully written down and a brand-new one will look wildly different on return on capital employed but broadly comparable on CROCI.
The number becomes useful when set against the weighted average cost of capital, the blended cost of the company's debt and equity funding. A CROCI comfortably above that cost means the business earns more than the money costs; a CROCI below it means capital is being destroyed however healthy the profit line looks.
The nuance is that gross capital invested depends on judgement calls: whether to include goodwill, whether to capitalise research spending or operating leases, and how to treat working capital. Two analysts can produce quite different CROCI figures for the same company, so the definition should always be stated.
In practice
Real-world examples.
Example
A group compares two divisions. Division A produces cash earnings of $18,000,000 on gross capital of $60,000,000 for a CROCI of 30%, while Division B produces $10,000,000 on $100,000,000 for 10%, so new investment is directed towards Division A.
Example
A retail chain with an ageing estate shows cash earnings of $45,000,000. Measured against net fixed capital of $180,000,000 the return looks like 25%, but against gross capital of $400,000,000 it is 11.25%, a far more sober picture of what the shops actually cost to build.
Example
An investor assesses an acquisitive group with cash earnings of $48,000,000. Excluding $160,000,000 of goodwill from a capital base of $400,000,000 gives 20%, while including it gives 12%, revealing how much of the return depends on ignoring what was paid for acquisitions.
Formula
Calculation
CROCI = (EBITDA - cash tax) / Gross capital invested, where gross capital invested = net working capital + gross property, plant and equipment + capitalised intangibles.
Take a mid-sized industrial products group. EBITDA for the year is $60,000,000 and the cash tax paid is $15,000,000, giving cash earnings of $60,000,000 - $15,000,000 = $45,000,000.
On the balance sheet, net working capital is $30,000,000, gross property, plant and equipment before accumulated depreciation is $120,000,000, and capitalised intangibles are $50,000,000. Gross capital invested = $30,000,000 + $120,000,000 + $50,000,000 = $200,000,000.
CROCI = $45,000,000 / $200,000,000 = 22.5%.
With a weighted average cost of capital of 9%, the spread is 22.5% - 9% = 13.5 percentage points, equal to 13.5% x $200,000,000 = $27,000,000 of value created in the year.Case study
Seen in the real world.
Kelmarsh Beverages is an illustrative drinks group invented for this example. Its established bottling operations produced cash earnings of $36,000,000 on gross capital invested of $150,000,000, a CROCI of 24% against a cost of capital of 8%.
Management proposed a new canning line costing $50,000,000 and forecast to add $6,000,000 of annual cash earnings, an incremental return of 12%. That still cleared the cost of capital, but it would pull the blended CROCI down to ($36,000,000 + $6,000,000) / $200,000,000 = 21%.
The fictional board approved the project anyway, on the reasoning that a 12% return beats leaving cash on deposit even though it dilutes the headline percentage. The illustrative lesson is that judging projects by their effect on an average return can lead a company to reject perfectly good investments.
Watch out
Common mistakes.
- Comparing a CROCI figure from one source with one from another without checking the definitions. Treatment of goodwill, leases and research spending varies widely between analysts.
- Rejecting a project simply because it would lower the group average. Any project earning more than the cost of capital adds value even if it dilutes the percentage.
- Using net rather than gross fixed assets. That defeats the entire purpose of the measure, which exists precisely to remove the effect of accumulated depreciation.
Questions
People also ask.
How does CROCI differ from return on capital employed?
Return on capital employed uses operating profit over net capital, while CROCI uses a cash earnings figure over gross capital, making it less sensitive to asset age.
What counts as a good CROCI?
A figure consistently above the weighted average cost of capital, with the gap sustained over several years rather than in one strong period.
Why do investors like gross capital invested?
Because it reflects the full amount of money committed to the business, so a company running old, written-down equipment cannot appear more efficient than one that has recently reinvested.
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