Calculate your profit with ROCE

May 23 2018 Written By: EduPristine

It is a clear fact that every business entity is operating in the market to earn a
profit. Profit making is the major objective of every business firm and this can be
achieved only when a company is highly efficient. Effective and optimum utilization
of company’s funds and capital leads to greater efficiency which ultimately leads
to higher profitability. It is also important for business firms to benchmark their
performance against the competitors in the market. Therefore, it becomes necessary
for a business firm to have a financial tool that can act as a base for its
performance measurement on a yearly basis. This is where the return on capital
employed i.e. ROCE helps companies to measure their business performance and
efficiency. ROCE also allows comparison of a company with the other companies
within the same sector/industry.
This article will help you in gaining an insight into return on capital employed &
the importance of return on capital employed and its various aspects that may help
you in calculating business profit against the capital employed.
Let’s start with the definition of ROCE first.

What is Return on Capital Employed?

Return on Capital Employed (ROCE) is a profitability ratio that helps to measure
the profit or return that a company earns from the capital employed, which is
usually expressed in the terms of percentage. It is used to determine the
profitability and efficiency of the capital investment of a business entity. It is
simply defined as a financial ratio that helps to determine the capital efficiency
and effectiveness of business.
Return on Capital Employed is generally calculated on the basis of two major
calculations/ components –
Operating profit
Capital employed
Operating Profit
It is the profit that a company earns from its business operations before the
deduction of taxes and interests. Therefore, it is also known as earnings before
interest and taxes (EBIT). It is calculated by deducting operating expenses and
cost of goods sold from revenues.
EBIT= Total revenues – [cost of goods sold (COGS) + Operating Expenses]
Capital Employed
It is the total amount of capital invested in the business operations by the
shareholders and other sources to earn a profit. It is also known as fund employed.
Capital employed is the sum of the equity of shareholders, all the debt
liabilities, and all the long-term finance.
Capital Employed= Total assets – current liabilities
Return on equity is another financial ratio used to calculate profit and people
often get confused between these two ratios. ROCE is considered better than the
Return on Equity as ROCE is helpful in evaluating company’s longevity and
durability. ROCE is also considered more beneficial as only the percentage return
of equity shareholders is calculated in Return on Equity (ROE) whereas in ROCE, the
return percentage of all the shareholders/ capital providers is calculated. Return
on capital employed of a company should be higher than its cost of capital in order
to remain in the market for a long run and only then it will be considered as a
good return on capital employed. Higher will be the ROCE of a company greater will
be the efficiency.
How is Return on Capital Employed calculated?
ROCE is calculated by using a simple formula. Various financial statements like
Balance Sheets, Profit/Loss account are used to calculate ROCE. As it is a
profitability ratio, it is calculated by dividing net operating profit of the
company with the employed capital.
The formula of calculating Return on Capital Employed
ROCE= Net Operating Profit (EBIT) / Capital Employed
OR
ROCE= Net Operating Profit (EBIT) / Total Assets – Current Liabilities
OR
ROCE= Net Operating Profit (EBIT) / Equity + Non- Current Liabilities
Apart from this ROCE can also be calculated with the help of return on capital
employed calculators available on the internet. You just have to enter your values
and you will get desired output without doing calculations manually.

Return on Capital Employed Ratio exactly shows the profit generated by each unit of
capital employed. It is important because it is used to measure the financial
performance of a business. It has built a strong position as a financial tool to be
used for evaluation in highly capital-intensive sectors like telecommunication,
infrastructure engineering, oil and gas companies, power utilities etc. The higher
rate of ROCE indicates how effectively a company is utilizing its funds. Before
calculating the return on capital employed a level business strategy is necessary
to be framed to check the applicability of ROCE in a particular business as ROCE
varies from industry to industry.

Industries these days are aware of the advantages of Return on capital employed.
Most of the industries, especially highly capital-intensive industries, use this
financial tool to achieve maximum profitability from the capital employed.

Some major benefits of ROCE are as follows:

Return on Capital Employed focuses on profit.
Facilitates improved company’s balance sheet management and profitability.
Helps managers gain knowledge about the effective utilization of capital.
Used for performance measurement of the company and helps investors in making
investment decisions.
Facilitates comparison of profitability of two companies of same sectors.
Useful in evaluating the growth forecast of a company.
Companies with high return on capital employed industry average can be spotted
with the help of Return on Capital Employed.
Besides the advantages, ROCE also has few drawbacks. One of the major limitations
of return on capital employed is that the returns are measured in the book value of
assets, which only favours the older companies. Sometimes the ambiguous and
debatable nature of ROCE also makes investors think twice. ROCE is calculated on
historical data and this again serves as a drawback of ROCE.
Conclusion
Companies with higher ROCE and greater efficiency are favoured by investors because
such companies tend to be more stable compared to the companies with low ROCE. We
have learned the importance of return on capital employed and every Industry should
consider ROCE as a powerful tool to get higher returns, therefore, it must be given
attention. Hence, we can say that calculating your profits with the return on
capital employed can bring more stability and efficiency to your business.