Return on Capital Employed
It is a method of calculating returns an entity earns on the capital it has invested in the business. Every business needs funds to source its operations. These funds are received by the company in form of equity and debt. And for this purpose, such invested funds in the business are referred to as capital employed. Return on the capital employed calculator is an online tool for calculating returns that a company earns on such capital investment.
The formula for calculating return on capital employed (ROCE) is as follows:
Return on Capital Employed = EBIT / Capital Employed
Some people also use the NOPAT (Net Operating Profit after Tax) instead of EBIT (Earnings before Interest and Taxes).
How to Calculate using Calculator?
The user has to provide the following data into return on capital employed calculator for a quick calculation.
It refers to the earnings of an entity prior to meeting interest and tax obligations. Since we are calculating returns for all the capital providers in common, the formula takes into account such earnings that are available for all the capital providers. Hence, EBIT is that portion of earnings or profits from which at first go the debt holders receive their interest. And, after paying taxes from the leftover earnings, preference shareholders receive their dividends. Further at the end, equity shareholders receive their Dividends.
Also, the denominator consists of all the capital invested in a business, so to maintain parity between numerator and denominator, we consider EBIT in the formula, which excludes interest payouts.
Capital employed means the total capital that a company invests in its business to continue its operations. It includes funds raised for a period of more than one year. Therefore, current liabilities are not a part of it. It is a sum total of the company’s share capital plus reserves and surplus plus long-term borrowings less preliminary expenses if any.
One more approach to calculate capital employed is:
Capital Employed = Total Asset – Current Liabilities
The above formula can be written as:
Capital Employed = Fixes Assets + Current Assets – Current Liabilities
i.e., Capital Employed = Fixed Assets + Working Capital
Again it can also be expressed as:
Capital Employed = Non-Current Assets (basically all long term assets) + Working Capital
Let us take an example for more clarity. The capital structure of a company consists of the equity share capital of $50,000, preferred stock of $20,000, reserves and surplus of $80,000. The long-term borrowings of the company equals $50,000. The operating profit of the company for the year was $35,000.
Total Capital Employed = $50,000 + $20,000 + $80,000 + $50,000 = $200,000
Return on Capital Employed = 35,000 / 200,000 = 17.5%
The return on capital employed determines what the company earns on capital it deployed or invested in the business. The return rate on stand alone basis does not convey anything. For any meaningful and right interpretation, one has to compare this rate with the weighted average cost of capital (WACC). WACC is the rate of return that investors (who have made investments in the form of equity or debt) expect from the company. If ROCE is greater than WACC, this means the company is making profits and earning over and above its financial cost.
Moreover, it also indicates that the company will have a surplus even after distributing returns to all the capital providers. And, if ROCE is less than WACC, it indicates that the company is not able to meet the expectations of capital providers. In that case, the first casualty would be the equity shareholders who may not get the dividends on their investments in the company.