Before most companies can begin generating profits, they must first invest capital. Capital can be in the form of any tangible assets that are used to conduct daily business such as:
● Equipment / tools
Logically, one might assume that the more capital a business has at its disposal, the more earnings it should be able to generate. However, this is not always the case once you also consider:
● The amount of debt that has been taken on to acquire the necessary capital
● Additional production does not necessarily translate into higher gross sales activity
● COGS (cost of goods sold) and overhead expenses may not be as lean as they could be
Therefore, businesses will use ROCE as a way of measuring how efficiently they work with these resources. Effectively, for every dollar of capital employed, ROCE answers the question of how much money should be expected in return.
ROCE can be used both internally and externally. Investors and analysts will identify it to draw comparisons between similar companies. It can also be used by owners and managers to set profitability targets for the quarter or year.
ROCE can be calculated as follows:
ROCE = EBIT / Capital Employed
● EBIT = Earnings before interest and tax. This figure is calculated by subtracting COGS and operating expenses from revenue and is typically reported as a standard line item on the company's income statement.
● Capital Employed = Total assets - Current liabilities. Though capital employed is not usually reported in financial statements, both assets and liabilities can be found on the company's balance sheet. (Note that capital employed can also be found by adding fixed assets and working capital.)
Suppose an investor has to choose between two companies: Company A and Company B.
● Company A is a large company with $6 million in profits.
● Company B is half the size of company A (by sales volume) and only generated $4 million in profits.
At first glance, Company A may seem like the better choice because it's larger and has generated more profit. However, after calculating ROCE, this may not be the case.
Consider the following additional details:
● Assets $100M
● Current liabilities $40M
● Capital employed $60M
● Operating profit $6M
● ROCE = 10%
● Assets $50M
● Current liabilities $25M
● Capital employed $25M
● Operating profit $4M
● ROCE = 16%
By examining the ROCE of each option, it's revealed that Company B is better at converting capital employed into profits.
Similar to other performance metrics, there isn't a single value for ROCE that differentiates good from poor. The best approach is only to compare from the same industry.
Ideally, companies with ROCEs that are trending higher over time are more desirable than those that don't. That's because it demonstrates that the company is able to do more with the resources it has at its disposal.
ROCE is a commonly used profitability metric that reveals how efficiently companies are at turning their capital employed into earnings. This is important to understand because it separates the company's assets from its current liabilities and relates them back to profits. ROCE can be used to set profitability targets as well as make comparisons between different businesses within the same industry.