What it means
Companies are funded by a mix of shareholders' equity and borrowing. ROCE looks at both sources together and asks how much operating profit they produced.
This makes it useful for comparing businesses with very different amounts of debt. The numerator is earnings before interest and tax (EBIT, the profit from operations before financing costs and tax).
The denominator is capital employed, which is usually total assets minus current liabilities. Capital employed is the money tied up in the long-term running of the business, such as equipment, property and working capital.
Investors use ROCE to judge quality. A company whose ROCE consistently exceeds its cost of capital, the return that lenders and shareholders require, is creating value.
One whose ROCE is lower is gradually destroying it, even if it reports a profit. ROCE is popular in capital-intensive industries such as utilities, telecoms, manufacturing and retail, where large investment in assets is needed.
Comparing it over several years shows whether the business is becoming more or less efficient. Comparing it with competitors shows who earns the best return from similar assets.
The nuance is that the result depends on definitions. Some analysts use average capital employed, others use the year-end figure, and cash held in the bank can distort the picture when it is large.
ROCE is also closely related to return on invested capital, which uses after-tax profit.
In practice
Real-world examples.
Example
A supermarket chain reports ROCE of 14% this year, up from 11%. The finance director credits closing weak stores and negotiating better terms with suppliers, and she notes that the freed capital was used to modernise its best locations.
Example
An investor compares two water utilities. Company A has ROCE of 7% and Company B has 5%, so she prefers A, but only after checking that A's assets are not understated because they were bought long ago and carried at old values.
Example
A technology company considers buying a competitor for $40 million. Its team estimates that the acquisition would add $4 million of EBIT, an ROCE of 10%, which is below the company's required return, so they negotiate a lower price.
Formula
Calculation
ROCE = EBIT / Capital Employed
Capital Employed = Total Assets - Current Liabilities
Worked example: A manufacturer reports EBIT of $900,000. Its total assets are $8,000,000 and its current liabilities are $2,000,000.
Capital employed = $8,000,000 - $2,000,000 = $6,000,000
ROCE = $900,000 / $6,000,000 = 0.15 = 15%
If the company's cost of capital is 10%, the extra 5 percentage points on $6,000,000 means about $300,000 of value created in the year ($6,000,000 x 5%).
Now compare it with ROCE based on average capital employed. If the opening figure was $5,000,000 and the closing figure $6,000,000, the average is $5,500,000, and ROCE = $900,000 / $5,500,000 = 16.4%. Using an average gives a slightly higher return because the business grew during the year.Case study
Seen in the real world.
Brackenridge Engineering is a fictional company that built a new factory costing $12 million. In this illustrative case, its group ROCE fell from 16% to 12% because the factory was complete but had not yet reached full output.
The finance director explained to the board that the new plant added $12 million of capital employed immediately, while its EBIT would grow over three years. She showed a chart of expected ROCE by year so that directors could see the dip was temporary. She forecast that at full production the factory would add $3 million of EBIT, a 25% return on its own capital, and lift the group figure back above its earlier 16%.
The board set a milestone: if the plant's ROCE had not passed 15% after two years, management would present a plan to improve it. By year two, the factory was at 16%, and the board approved a similar investment. Directors also asked that every future project proposal state its expected ROCE in each of the first five years.
Watch out
Common mistakes.
- Using net profit instead of EBIT. ROCE is meant to measure operating returns before financing and tax.
- Ignoring the timing of investments. A big new project raises capital employed before it raises profit, so ROCE can dip temporarily.
- Comparing across industries without care. A software firm and a steelmaker have very different capital needs.
Questions
People also ask.
What is a good ROCE?
It should comfortably exceed the company's cost of capital. Many investors treat anything consistently above 15% as strong, though it depends on the sector. A regulated utility with steady income may be perfectly healthy at a much lower figure.
How does ROCE differ from ROE?
ROE considers only shareholders' equity and is affected by debt, while ROCE considers all long-term capital. This makes ROCE the fairer measure when comparing a heavily borrowed company with a debt-free one.
Should cash be deducted from capital employed?
Some analysts deduct large surplus cash to avoid a misleading result, but a simple ROCE leaves it in. Whichever approach you choose, apply it consistently across years and competitors.
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