Return on Capital Employed (ROCE) is a profitability ratio that helps determine the profit that a company earns for the capital it employs. ROCE is measured by expressing Net Operating Profit after Taxes (NOPAT) as a percentage of the total long-term capital employed. In other words, ROCE can be defined as a rate of return earned by the business as a whole. Like ROE (equity), calculates % return of equity shareholders, ROCE calculates % return of all the capital providers together. If a business is financed completely by equity, ROE and ROCE will be same.
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RETURN ON CAPITAL EMPLOYED (ROCE) FORMULA AND ITS CALCULATION
ROCE can be calculated using a simple formula. The calculation of ROCE is simple and can be easily calculated using financial statements of a company i.e. Profit and Loss Account and Balance Sheet. The NOPAT can be worked out from P/L a/c and average capital employed from the balance sheet.
Return on Capital Employed
Average Capital Employed
Average Capital Employed: Return on capital employed takes into consideration only the long-term borrowed funds. Thus, current liabilities are not considered while calculating capital employed. Capital employed is calculated as follows.
Capital Employed = Share Capital + Reserves and Surplus + Long Term Loans (Secured + Unsecured) – Capital Work in Progress – Investment Outside Business – Preliminary Expenses – Debit Balance of Profit and Loss A/c.
Average Capital Employed = (Opening Capital Employed + Closing Capital Employed) /2
Net Operating Profit after Taxes (NOPAT): It is the operating profit of the business activities that are financed by the capital employed as calculated above. Since we have deducted ‘Investment outside Business’ from the capital employed, we should deduct the profits or returns received due to those investments if included in the profits. In essence, the numerator and denominator should be comparable and consistent with each other.
NOPAT = PAT + Interest – Tax Shield
NOPAT = EBIT (1-Tax)
RETURN ON CAPITAL EMPLOYED (ROCE) CALCULATIONS USING EXAMPLE
XYZ Co. All figures in USD.
|Reserves and Surplus||1,00,000||Interest||10,000|
|Long Term Loans||40,000||EBT||40,000|
|Current Liabilities||10,000||Tax (40%)||16,000|
NOPAT = EAT + Interest – Tax Shield
NOPAT = 24,000 + 10000 – 10,000 (40%)
NOPAT = 34,000 – 4000
NOPAT = 30,000
Capital Employed = Share Capital + Reserves & Surplus + Long Term Loans
Capital Employed = 60,000+100,000+40,000
Capital Employed = 200,000
Therefore, Return on Capital Employed (ROCE) = NOPAT / Capital Employed
ROCE = 30,000 / 200,000
ROCE = 0.15 = 15%
Thus, from the above illustration, we can conclude that for every dollar of capital employed by the company, 15% of it is generated into operating profits. To put it in other words, to earn every dollar, the company needs to employ 6.67 (100/15) dollar worth of capital.
Interpretation of Return on Capital Employed (ROCE)
In our example, we have ROCE of 15%. Is it good or bad? To answer this question, we have to compare this 15% with Post Tax Weighted Average Cost of Capital (WACC) of the company. Why and how these two metrics are comparable? On one hand, the ROCE works out a return that is earned by total capital employed of the company which includes both equity shareholder funds and long-term debt. On the other hand, WACC talks about the combined required rate of return of the company i.e. both required rate of returns by equity holders and interest rate expected by debt holders are considered. Thus, ROCE is return earned and WACC is return required and therefore are very much comparable.
Now, if ROCE is greater than WACC, the company is creating value and the shareholders will remain invested in the company till this situation continues. If ROCE is less than WACC, it is destroying shareholder’s value. The company will have to pay interest to the debt holders as they have first right on profits and remaining profits will be available for equity shareholders and that will not satisfy the required rate of returns by equity and hence, the investor considers exiting the company.
Investors can also use ROCE figure to analyze the performance of a company or compare the performances of different companies within the same sector. If 2 companies in same sectors have more or less same amount of capital employed, the company with better ROCE would, without the doubt, have made a better use of the employed funds. We can safely assume that such a company would have made better use of its resources.Last updated on : March 23rd, 2019