What is Return on Capital Employed? Why is it so Important to Check before Investing??

What is Return on Capital Employed?

Return on Capital Employed (ROCE) is a financial statistic that is used to analyze the profitability and capital efficiency of a company. The ROCE ratio helps in determining how easily and successfully a company can generate profit from the capital at its disposal. It is also one of the key indicators used by investors, fund managers, stakeholders, etc to evaluate the company’s performance.

Content:

ROCE meaning in Share Market?

ROCE is a long-term profitability ratio. It is so because ROCE indicates the effectiveness of asset performance. Therefore, it can be useful in evaluating the longevity of the said company. 

Now, in order to operate for long, the ROCE of the company should be higher than the cost of capital. It is important to note that many investors prefer ROCE over return on equity (ROE) as ROE only analyses the profitability related to shareholder’s equity. 

ROCE takes into account equity and debt, which are key for analyzing a company’s financial performance. 

Return on Capital Employed Formula

With the definition and explanation out of the way, let’s see how to calculate Return on Capital Employed.

Here is the formula for Return on Capital Employed Formula:

ROCE = EBIT / Capital Employed

Where, 

EBIT = Earning before interest and tax

Capital Employed = Total Assets – Current Liabilities

So, what is EBIT? EBIT is earnings before interest and tax. EBIT is derived by deducting the cost of goods sold and operating expenses from total revenue. EBIT is also known as operating income. EBIT shows how much profit a company generates from its operations. 

What is capital employed? It is calculated by deducting current liability from total assets plus working capital. 

Now, let’s move to the calculations

Presume a company has net operating earnings of ₹20 lakhs. Total assets declared by the company are worth ₹1.8 crores, and current liabilities are ₹8 lakhs. 

So, ROCE will be…

Return on Capital Employed (ROCE) = EBIT/(Capital Employed)

ROCE = 20,00,000/(1,80,00,000 – 800,000)

Return on Capital Employed (ROCE) = 11.62%

ROCE vs ROE

Let’s see the much-talked-about differences between ROCE and ROE

  • ROE assess how efficiently the equities are managed by the company. ROCE assesses how efficiently the employed capital is being used.
  • ROE ratio is from the investor’s point of view as it focuses on equity. ROCE ratio is from the company’s point of view as it focuses on the total capital employed.
  • ROE uses Net Profit calculation. ROCE uses EBIT for calculation.
  • ROE interprets profitability for equity shareholders. ROCE interprets profitability for all the stakeholders.

How to use ROCE for Investment?

Investors and fund managers apply the ROCE ratio to compare firms within the same sector. This helps them to decipher which company is using its money most effectively to generate healthy returns. This can help them make informed decisions about investing.

A Higher ROCE ratio is considered good because the company generates more profits on every single rupee of capital invested. But, it can also mean higher cash in hand as it is a part of total assets. 

From investing perspective, ROCE can be very useful for measuring the financial efficiency of a company. It is so because ROCE calculates profitability after deducting the amount of capital required.

Quick Summary

  • ROCE is a financial statistic that is used to analyze the profitability and capital efficiency of a company.
  • ROCE takes into account equity and debt, which are key for analyzing a company’s financial performance. 
  • The formula for Return on Capital Employed Formula: ROCE = EBIT / Capital Employed
  • Investors and fund managers apply the ROCE ratio to compare firms within the same sector. This helps them to decipher which company is using its money most effectively to generate healthy returns.

FAQ

What is a Good ROCE?

There is no set parameter for something to be called a good ROCE. However, a greater return on capital utilized shows a more productive firm. But if there is too much cash on hand, it would mean that the capital has not been employed; hence the stats will be skewed.

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Vikas Yadav

Vikas Yadav is a professional writer who also happens to be an engineer. He's been creating content for quite some time now, but it was his fascination and zeal for the stock market that steered him in the right direction. He is eager to spread knowledge about the "power of investment" through his collaboration with Alice Blue by creating high-quality educational content for the public at large. If you want to comprehend difficult subjects in simple terms, he's your man.

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