What is Return on Capital Employed
Return on capital employed is a financial ratio that measures the company’s ability to generate profit by using the capital invested in the business. The return on capital employed (ROCE) value reflects the amount of profit for each dollar of invested capital.
The return on capital employed (ROCE) is the percentage of profit generated by the company’s capital employed. Thus, the higher return on capital employed, the more profit generated from their invested capital. Additionally, an increasing ROCE ratio implies strengthening long-term profitability.
In contrast, the lower ROCE reflects that the company has lower efficiency in using capital.
The ROCE is useful when the investors evaluate the company’s long-term performance and overall longevity. Additionally, since the number affects both equity and debt, making it is very useful for investors to compare different companies in the same industry over a specific forecast period.
The only thing you need to be wary of the return on capital employed is that it measures return against the book value of assets. As these are depreciated the ROCE will increase even though cash flow has remained the same. Thus, the older company with depreciated assets will tend to have higher ROCE than the newer company.
Return on Capital Employed Formula
The return on capital employed can be calculated by dividing the company’s profit after tax (EBIT) by the capital employed, or as the following return on capital employed formula:
ROCE = (EBIT ÷ Capital employed) x 100
Where:
- Capital employed = Total assets – Current liabilities
- EBIT is earnings before income and tax (profit after tax).
For example, from the balance sheet the Feriors company has the following results:
- Capital employed: $6,000,000
- Total assets: $6,020,000
- Current liabilities: $20,000
- EBIT: $1,000,000
ROCE = (1,000,000 ÷ 6,000,000) x 100 = 16.67%
From the example, this means the Feriors generate 16.67 cents for each dollar of capital invested.
FAQs
Return on capital employed is a financial ratio that measures the company’s ability to generate profit by using the capital invested in the business.
The return on capital employed can be calculated by dividing capital employed by the profit after tax as the following formula: ROCE = (EBIT ÷ Capital employed) x 100
The higher number is a good return on capital employed value because the higher return on capital employed reflects more profit generated from their invested capital.
