Return on Capital Employed (ROCE): Definition and Calculation

Working on your business is just as important as working in your business – and that includes keeping a close eye on your key performance indicators (KPIs). Essentially – measuring the current and future financial health of your business.

With so many KPIs and accounting ratios available, why should you use ROCE? 

Because this accounting ratio proves your efficiency at generating returns on your capital investments. This is crucial information for any future investors and to ensure your business’s successful growth.

Business owners often prioritise ROCE over other accounting ratios because of its significance to investors. It’s part of a common language when comparing the profitability of different businesses, as well as being useful for your own internal financial tracking. 

Here’s What We’ll Cover:

Definition of Return on Capital Employed (ROCE)

How to Calculate Return on Capital Employed

Example of Using Return on Capital Employed Calculation

What Else Do I Need to Know About Return on Capital Employed?

Definition of Return on Capital Employed (ROCE)

A Return on Capital Employed calculation is based on each accounting period and needs two pieces of information about your business:

• Earnings before interest and tax (EBIT)
• Capital Employed

What Is EBIT?

This figure is what a business earns, without any consideration for interest or tax. It’s also called operating income. You work out your EBIT by deducting expenses and cost of goods sold from your revenue. So, you already know this! 

What Is Capital Employed?

Initially, this feels like a strange term. How can your capital be employed? But if you think about it, you make your money work for your business all the time. It’s ‘employed’ every time you invest in something to help your business grow. 

The ROCE tells you how well you’re employing your capital to make a profit. It’s a financial ratio that compares your yearly pre-tax profit with your capital employed. Looking at the longer-term picture, a company’s return on capital employed needs to be greater than its average cost of capital. Otherwise shareholders earn less and less as operating costs deplete profits. 

As an accounting term, capital employed usually means the value of your total current assets minus current liabilities. This is the same as your shareholders’ equity, minus long-term liabilities. Essentially, a profitability ratio.  

There are occasions where potential investors will want to work from an average capital employed figure. This means that they look at your company’s position during a fixed period of time. They use the capital employed number at the start and end dates to calculate ROCE on their average. 

The ROCE figure is worked out by dividing your EBIT by your capital employed and then turning that number into a percentage. The higher the percentage, the better. It indicates future higher earnings per share. 

How to Calculate Return on Capital Employed

Brave faces everyone, here comes the maths bit…

This equation summarises the explanation above. 

ROCE = EBIT ÷ Capital Employed

Some analysts use this language in their equation instead: 

ROCE = Net Operating Profit  ÷ Capital Employed (or, Employed Capital)

The results are the same.

Example of Using Return on Capital Employed Calculation

Imagine you’re competing with another company for investment. One of the key pieces of information they’re going to use is your Return on Capital Employed.

Your company has £400,000 of assets and £100,000 in liabilities. So your total capital employed is £300,000. And your EBIT is £400,000. 

Let’s work out your Return on Capital Employed using the calculation above:

£400,000 (EBIT) ÷ £300,000 (Capital Employed) = 1.33 (ROCE)

So every £1 employed by your business earns £1.33. Profitability of 133%.

The competing company is much bigger than yours, its EBIT is £700,000. It has £800,000 of assets and £160,000 of current liabilities. So this rival company has a Capital Employed of £640,000.

£700,000 (EBIT) ÷ £640,000  (Capital Employed) = 1.09 (ROCE)

So they only earn £1.09 for every £1 in capital employed. Profitability of 109%.

Whatever other factors this investor is considering, although yours is a smaller company, you have a better return on capital employed. Which may tip the scales in your favour!

What Else Do I Need to Know About Return on Capital Employed?

There are just a few other things you need to know about using ROCE. It’s a really useful measure in some circumstances, but there are limitations, so it should form part of wider investment advice. Knowing how to make best use of ROCE is what makes it valuable to your business. 

Pros of ROCE

• ROCE is a good indicator of your business’s ability to make a profit from its capital. Great information when you’re working out long-term financial decisions. 
• A ROCE calculation gives a specific number, showing how much profit per £1 you’re generating. And this particular ratio involves both equity and debt, making it very useful for investors comparing different companies within the same industry over a set forecast period.
• To bolster your position, showing stable ROCE over several years can also be an important element to an investor’s decision.

Cons of ROCE

• It’s not a reliable predictor of future sales or earnings.
• It’s a gauge of profitability, regardless of the size of the business. This means that it’s not very useful for investors comparing businesses in different sectors. 
• If your business has large amounts of cash reserves, then it’s likely to show a low ROCE. This doesn’t mean that the value of the cash is diminished, it provides its own benefit to investors. It just means that it’s not a factor that’s included in the ROCE equation. 

Using multiple measures allows business owners to look at their finances from several different angles. Return on Capital Employed is just one ratio that you can use in your analysis for future growth predictions. It’s the same for any potential investors – they won’t just consider your ROCE number, it’ll be part of their overall investigation into your attractiveness as a prospect. 

There’s no accounting equation that allows any of us to confidently predict that past performance is guaranteed in the future. Unfortunately.

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