What is ROCE?
The Return on Capital Employed (ROCE) measures the efficiency of a company at deploying capital to generate sustainable, long-term profits.
In practice, the ROCE is a method to ensure the strategic capital allocation by the management team of a company is supported by sufficient returns.
How to Calculate ROCE
ROCE, shorthand for “Return on Capital Employed,” is a profitability ratio comparing a profit metric to the amount of capital employed.
The return on capital employed (ROCE) metric answers the question of, “How much in profits does the company generate for each dollar in capital employed?”
Given a ROCE of 10%, the interpretation is that the company generates $1.00 of profits for each $10.00 in capital employed.
ROCE can be a useful proxy for operational efficiency, particularly for capital-intensive industries.
- Telecom and Communications
- Oil & Gas
- Industrials and Transportation
- Manufacturing
The calculation of return on capital employed is a two-step process, starting with the calculation of net operating profit after taxes (NOPAT).
NOPAT, also known as “EBIAT” (i.e. earnings before interest after taxes), is the numerator, which is subsequently divided by capital employed.
The denominator, capital employed, is equal to the sum of shareholders’ equity and long-term debts, i.e. total assets less current liabilities.
More specifically, all the assets sitting on a company’s balance sheet – i.e. the resources with positive economic value – were originally funded somehow, either using equity or debt (i.e. the accounting equation).
If we deduct current liabilities, we are removing the non-financing liabilities from total assets (e.g. accounts payable, accrued expense, deferred revenue).
That said, the capital employed encompasses shareholders’ equity, as well as non-current liabilities, namely long-term debt.
ROCE Formula
The formula for calculating the return on capital employed (ROCE) metric is NOPAT divided by the average capital employed.
In contrast, certain calculations of ROCE use operating income (EBIT) in the numerator, as opposed to NOPAT.
Since profits paid out in the form of taxes are not available to financiers, one can argue that EBIT should be tax-affected, resulting in NOPAT.
Regardless, ROCE is unlikely to deviate much whether EBIT or NOPAT is used, although be sure to maintain consistency in any comparisons or calculations.
