What is ROCE?
The Return on Capital Employed (ROCE) metric measures the efficiency of a company at deploying capital to generate profits, i.e. ensures the management team’s strategic allocation of capital is supported by sufficient returns.
How to Calculate ROCE (Step-by-Step)
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:
- “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.
- NOPAT = EBIT × (1 – Tax Rate %)
The denominator, capital employed, is equal to the sum of shareholders’ equity and long-term debts.
- Capital Employed = Total Assets – 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 expenses, deferred revenue).
That said, the capital employed encompasses shareholders’ equity, as well as non-current liabilities, namely long-term debt.
- Capital Employed = Shareholders’ Equity + Non-Current Liabilities
ROCE Formula
The formula for calculating the return on capital employed (ROCE) metric is as follows.
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.
What is a Good ROCE? (High or Low)
Generally speaking, the higher a company’s return on capital employed (ROCE), the better off the company likely is with regard to generating long-term profits.
- Higher ROCE: Implies the capital employment strategies of a company are more efficient.
- Lower ROCE: Potential signal that the company could be spending funds unproductively (i.e. there is substantial “waste” in capital allocation).
The average ROCE will vary by industry, so comparisons must be done among peer groups comprised of similar companies to determine whether a given company’s ROCE is “good” or “bad”.
The current ROCE of a company can also be viewed in relation to that of its historical periods to assess the consistency at which capital is efficiently deployed.
Stability in maintaining a high ROCE year after year can build the case that a company possesses an economic moat and can achieve excess returns on capital over the long run.
