What it means
Capital employed is the pool of money that is genuinely tied up in the business for the long haul: shareholders' equity plus long-term borrowing. ROCE asks what operating return that pool produces each year.
It deliberately ignores interest and tax so that two companies with different debt levels can still be compared fairly. The measure matters most in capital-intensive industries where large sums are locked into plant, property and equipment for years.
A board deciding whether to build a new facility wants to know whether the extra capital will earn more than the company's existing capital does, and more than the cost of raising it. If ROCE sits below the cost of capital, the business is destroying value even while reporting a profit.
ROCE is calculated from published accounts, which makes it a favourite of external analysts. Operating profit, often labelled EBIT, comes from the income statement, while capital employed is derived from the balance sheet by subtracting short-term obligations from total assets.
Many people cross-check that figure by adding equity to non-current liabilities, which should give a similar number. The ratio is most informative over time and against close peers.
A ROCE that has drifted down for several years usually means the company is adding capital faster than it is adding profit, which is common after a run of acquisitions. A sudden jump can be genuine improvement, but it can equally follow an asset write-down that shrank the capital base.
Two practical cautions are worth remembering. Companies that lease heavily, hold large cash balances or carry goodwill from acquisitions can all show distorted figures, so analysts often strip out surplus cash or intangibles to get a cleaner comparison.
ROCE also says nothing about cash timing, so it should sit alongside a cash flow measure rather than replace one.
In practice
Real-world examples.
Example
A quarrying company reports ROCE of 18% while its nearest competitor reports 11%. Investors press the competitor's management to explain the gap, and the answer turns out to be an underused processing plant bought three years earlier.
Example
A retail chain's ROCE falls from 16% to 10% after opening twenty new stores. The board accepts a temporary dip while the stores mature, but sets a target of returning to 15% within three years and ties part of executive pay to it.
Example
A private equity owner uses ROCE as the primary performance measure for a portfolio manufacturer, because it cannot be improved simply by borrowing more, which stops management flattering the numbers with financial engineering.
Think of it
“ROCE shows how much operating profit the company generates for every dollar of long-term capital invested in the business.
Formula
Calculation
Return on Capital Employed = Operating Profit (EBIT) / Capital Employed, where Capital Employed = Total Assets - Current Liabilities
Consider a commercial laundry group. Its accounts show operating profit of $4,200,000, total assets of $26,000,000 and current liabilities of $6,000,000.
Capital employed = $26,000,000 - $6,000,000 = $20,000,000.
ROCE = $4,200,000 / $20,000,000 = 0.21, or 21%.
The business earns 21 cents of operating profit for every dollar of long-term capital tied up in it. If the group's weighted average cost of capital is 9%, it is comfortably creating value; a proposed $5,000,000 expansion would need to add at least $450,000 of operating profit just to break even against that cost, and around $1,050,000 to maintain the current 21% standard.Case study
Seen in the real world.
What follows is an illustrative, fictional example. Ashgrove Cold Storage, an invented refrigerated warehousing business, was proud of growing operating profit from $2,000,000 to $4,200,000 in four years. The chief executive presented the profit chart at every board meeting.
A non-executive director asked for the ROCE trend instead. It showed capital employed had grown from $10,000,000 to $30,000,000 over the same period, so ROCE had actually fallen from 20% to 14%. The company had been buying warehouses in locations that filled slowly, and each acquisition added more capital than profit.
The board changed its investment rule so that no new site could be approved unless it was forecast to reach a 15% return on the capital it consumed within three years. In this fictional scenario, growth slowed, but by the following year ROCE had stabilised and the cost of the group's borrowing facility was renegotiated downwards.
Watch out
Common mistakes.
- Using net profit after interest and tax in the numerator. ROCE is designed to measure operating performance before financing effects, so using post-interest profit defeats the purpose and makes indebted companies look artificially weak.
- Forgetting to subtract current liabilities from total assets. Including short-term payables in capital employed inflates the denominator and understates the return.
- Comparing ROCE between companies with very different intangible balances. A business that grew organically carries no goodwill and can look far better than an equally good acquirer that does.
Questions
People also ask.
Is ROCE the same as ROIC?
They are close cousins, but return on invested capital normally uses operating profit after tax and defines the capital base more precisely, while ROCE uses pre-tax operating profit.
What is a good ROCE?
A common rule of thumb is that ROCE should comfortably exceed the company's cost of capital, so a business borrowing at 8% would want a figure well into the teens.
Can ROCE be manipulated?
It can be flattered temporarily by writing down assets, delaying capital spending or holding assets off the balance sheet, which is why the multi-year trend matters more than any single year.
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