Return on Capital Employed (ROCE) is a key financial metric used to evaluate a company’s profitability relative to the capital invested in the business. While the basic formula for ROCE is straightforward, there are several variations in how it can be calculated, depending on the approach to defining operating profit and capital employed. Understanding these different methods provides a more nuanced view of a company’s financial performance.
1. Standard Formula for ROCE
The most commonly used formula for ROCE is:
- ROCE = (Operating Profit / Capital Employed) × 100
Where:
- Operating Profit (also known as EBIT) is the profit generated from the company’s core business operations before interest and taxes.
- Capital Employed is the total capital used in the business, typically calculated as total assets minus current liabilities or as equity plus non-current liabilities.
2. Example Data for Calculations
Let’s consider the following financial information for XYZ Ltd:
- Revenue: $1,000,000
- Operating Profit (EBIT): $150,000
- Net Profit (after interest and taxes): $120,000
- Total Assets: $800,000
- Current Liabilities: $200,000
- Shareholders’ Equity: $400,000
- Non-Current Liabilities (Long-Term Debt): $200,000
3. Method 1: Using Total Assets Minus Current Liabilities
This is the standard approach, where capital employed is calculated as total assets minus current liabilities.
- Capital Employed = Total Assets – Current Liabilities
- Capital Employed = $800,000 – $200,000 = $600,000
ROCE = (150,000 / 600,000) × 100 = 25%
Interpretation:
Using this method, XYZ Ltd has an ROCE of 25%, indicating that the company generates 25% profit from the capital invested in its operations.
4. Method 2: Using Equity Plus Non-Current Liabilities
In this method, capital employed is calculated by adding shareholders’ equity and non-current liabilities (long-term debt).
- Capital Employed = Shareholders’ Equity + Non-Current Liabilities
- Capital Employed = $400,000 + $200,000 = $600,000
ROCE = (150,000 / 600,000) × 100 = 25%
Interpretation:
This method gives the same ROCE as the previous method (25%) because the definition of capital employed aligns with total assets minus current liabilities. However, it explicitly shows the contribution of equity and long-term debt.
5. Method 3: Using Average Capital Employed
Some businesses prefer to use the average capital employed over a period to account for fluctuations in asset levels.
- Beginning Capital Employed: $550,000
- Ending Capital Employed: $600,000
- Average Capital Employed = (550,000 + 600,000) / 2 = $575,000
ROCE = (150,000 / 575,000) × 100 ≈ 26.09%
Interpretation:
Using average capital employed gives a slightly higher ROCE of approximately 26.09%, reflecting the company’s growth in capital over the period.
6. Method 4: Using Net Profit Instead of Operating Profit
Although less common, some analysts use net profit instead of operating profit, which accounts for interest and taxes, providing a measure of return to equity holders and debt holders after all expenses.
- Net Profit = $120,000
- Capital Employed = $600,000
ROCE = (120,000 / 600,000) × 100 = 20%
Interpretation:
Using net profit results in a lower ROCE of 20%, reflecting the impact of interest and taxes on profitability. This method may be useful for understanding the return after financing costs but is less consistent for comparing operational efficiency.
7. Method 5: Adjusted Capital Employed (Excluding Non-Operating Assets)
In some cases, analysts exclude non-operating assets (like investments or surplus cash) to focus on capital directly tied to business operations.
- Total Assets: $800,000
- Non-Operating Assets (Investments): $100,000
- Adjusted Capital Employed = (800,000 – 100,000) – 200,000 = $500,000
ROCE = (150,000 / 500,000) × 100 = 30%
Interpretation:
Excluding non-operating assets increases the ROCE to 30%, highlighting the efficiency of core operations. This approach is useful when evaluating the performance of the business’s primary activities.
8. Summary of ROCE Calculations
| Method | ROCE |
|---|---|
| Standard Method (Total Assets – Current Liabilities) | 25% |
| Equity + Non-Current Liabilities | 25% |
| Average Capital Employed | 26.09% |
| Using Net Profit Instead of Operating Profit | 20% |
| Adjusted Capital Employed (Excluding Non-Operating Assets) | 30% |
9. Choosing the Right ROCE Calculation Method
The method chosen to calculate Return on Capital Employed (ROCE) depends on the specific goals of the analysis. The standard method using operating profit and total capital employed provides a clear picture of operational efficiency, while adjustments for non-operating assets or average capital can offer more refined insights. Using net profit reflects the impact of financing decisions but may not provide a consistent basis for comparing operational performance across companies.
Ultimately, understanding these different approaches helps analysts and stakeholders interpret ROCE accurately and make informed decisions about a company’s financial health and operational efficiency.