Return on Capital Employed (ROCE) is a financial metric that evaluates a company’s profitability by measuring the efficiency with which it generates profits from its capital employed, considering both debt and equity financing.
Primary Implication
Your Return on Capital Employed Ratio tells you how many dollars in profits are generated by each dollar of capital employed. Use this ratio to appreciate how well your assets are performing.
Any asset that generates lower returns than what it costs to pay back debt funding is a failed asset as long as it doesn’t contribute more not earnings that takes in cash to have it. A low ROCE tells you that management is inefficient at using the capital employed in assets to generate sales at a profit.
Fix this by either increasing profits or unloading underperforming assets.
Overview
The Return on Capital Employed (ROCE) is a Profitability Ratio that refers to the total assets of a company, less its current liabilities. ROCE is also viewed as stockholders’ equity, less long-term liabilities. Both equal the same figure, which measures how efficiently a company generates profits from its capital employed, by comparing operating profit to capital employed.
ROCE is more useful than ROE in evaluating the longevity of a company. This is because ROCE shows how many dollars in profits are generated by each dollar of capital employed.
ROCE also considers long-term financing in looking at asset performance—to confirm whether the assets generate returns at a higher rate than what it costs to borrow funding to secure these assets. To put it simply, if a company borrows at 10%, and can only achieve a return of 5%, they are losing money.
The formula for Return on Capital Employed is as follows:
Operating Income / (Total Assets – Current Liabilities)
A ratio of 1 means operating income equals the capital employed by that company to produce that income. I.e., the company is generating one dollar of profit for every dollar of capital employed. A 0.2 return indicates that for every dollar invested in capital employed, the company made 20 cents of profits.
Higher is Better: this means that more dollars of profits are generated by each dollar of capital employed.
Lower is Worse: management is inefficient at using capital employed, which becomes a real problem when the ratio is lower than the borrowing rate.
You can’t earn a return on the capital in your business being employed to generate sales at a profit if you aren’t proactively managing your business for profits. Too many management teams react to business issues and problems rather than manage their business to make money.
Profit Management is the organization and coordination of the activities of a business to achieve defined business objectives at a profit. When everyone on the management team is pulling together to convert sales into profits, there are fewer surprises that distract management’s attention and rob you of profitable cash flow.
