ROCE, which measures how efficiently a company can generate profits from the capital employed, is a ratio that helps to throw light on how efficient a business is.
If you want to invest in stocks, it is essential to know about stock markets and related terms. This can be only be gained through experience and fundamental and technical analyses of the industry. You need to understand basic metrics like a company’s financial history, its current financial strength and profitability ratios before choosing to invest in its stock.
Some of the profitability ratios you need to consider are, return on assets, return on equity and return on capital employed ratio also called ROCE. We will talk more about what is ROCE and also look see how it is calculated by understanding the return on the capital employed formula.
What is ROCE?
Before we look at Return on Capital Employed-ROCE meaning, it is essential to note is that every business entity operates to earn a profit. A company can achieve profits only when it is highly efficient. For that, a company needs to make optimal use of its funds and capital. It is also essential for a company to benchmark its efficiency against its competitors. Therefore businesses need a financial tool or a ratio that helps to measure its effectiveness or performance. This is where the return on capital employed rate comes in because it helps a company to compare itself with others in the same sector or industry.
ROCE is essentially a profitability ratio. It measures how efficiently a company can generate profits from the capital employed. For doing this, it compares net operating profit to capital employed. In other words, ROCE shows how many rupees in profit each rupee of capital employed generates.
Return on Capital Employed formula: The ratio is based on two parameters, operating profit, and capital employed. Net operating profit is also referred to as EBIT or earnings before interest and taxes. EBIT thus includes gains but excludes interest and taxes. The formula is:
ROCE = EBIT/Capital Employed
Whereas capital employed = Total assets – current liabilities
This formula can be put into an Excel sheet or software to create an ROCE calculator. You have to understand that comparing EBIT values alone of two companies is not the right way to choose a company.
Lets us take an example to see how the ROCE calculation works. Let’s assume that company X has an EBIT of Rs 200 crore in a particular year. On the other hand, company Y has an EBIT of Rs 150 crore in that year. One might think that company X is a better investment as the EBIT is higher. However, that is not the correct way to decide how profitable a company is. To do that, one has to look at the ROCE of both the companies.
In the same example, let us say that capital employed for company Y is Rs 1,000 crore and capital employed by company Y is Rs 600 crore.
By using the ROCE formula, we can see that returns for company X are 20 percent while for company Y they are 25 percent. So it shows that company Y is a better investment since ROCE is higher. This is, of course, a fundamental example, but it conveys the idea.
Now, let us look at the significance of ROCE and its uses.
- A higher ROCE means that a company has used its capital more efficiently.
- The return on capital employed ratio is useful when comparing companies in capital intensive sectors like Telecom and Power. This is because it also considers debt and other liabilities and not just profitability.
- A company that has a stable rate over the years is also indicative of excellent performance. Investors tend to prefer companies with a consistently rising ROCE as opposed to companies where it fluctuates.
However, ROCE has one drawback. It measures returns against the book value of assets as these assets depreciate, the ratio will go up even if the cash flow remains constant. This would mean that older businesses with depreciated assets will be having higher ROCEs than newer companies which might be better.
We have seen ROCE’s meaning and its importance in measuring business efficiency. Along with other financial ratios, it can help an investor make informed decisions as far as his investments are concerned.
