ROCE is one of the tools in the tool box of a financial analyst. This is a useful ratio which would calculate the performance of a particular investment or can be applied on different investments. It can be used for one period as well as for multiple periods.
Return on Capital Employed (ROCE) = Profit Before Interest and Tax (PBIT)
Capital employed means total assets minus current liabilities. From an investor’s perspective, a higher ratio is better. An investor can compare two ROCE on two investments and find out which one performed better.
The formula is quite simple and interesting, all you have to do is to divide the profit on your capital employed, phew, you’ll get your ROCE (Return on Capital Employed).
So, take a basic example first, let’s say that you commenced a trading business with your life-long saving of $50,000. This business earned you a PBIT (Profit before interest and tax) of $10,000. So, how was much was your return on capital employed.
ROCE = $10,000 / $50,000 * 100 = 20%
Thus, Return on Capital Employed is 20% for one year. Now, question is, if you run the same business for 5 years, and you earn $20,000 each year, how much will be your ROCE and how to calculate it.
If we need to calculate 5 year’s ROCE, then we need to calculate as follows:
|Year||Return ($) in present value||ROCE (on investment of $50,00)|
In the above table, we can see that ROCE ratio has been calculated for each of the 5 years. However, if we want to calculate average Return on Capital Employed in the five years, we can take an average by dividing 106% by 5 resulting in answer of 21.2% average annual Return on Capital Employed (ROCE).
Key features of ROCE ratio:
- The formula for ROCE is simple to understand and calculate. You don’t need to be a CFA charterholder in order to calculate ROCE. An investor can easily calculate this ratio.
- ROCE is easy to understand and explain. An investor can himself identify a better investment by calculating ROCE of two investments. For example, if Return on Capital Employed of company A is 20% and the ROCE for company B is 15%, then the company A is a wise investment choice.
- ROCE can be used across different sectors and industries and even across different geographies. This measure work in almost all organization types. You don’t need to make changes for making two investments comparable.
- It is a good performance measurement tool and performance of different products, divisions, companies and countries can be calculated and compared easily. Therefore, the ROCE ratio is used for multiple purposes.
- Minimum data input is required for calculation of Return on Capital Employed. The profit figure is mostly available from the annual report or published condensed financial statements of companies.
Draw backs of ROCE ratio:
- ROCE does not itself take into account time value of money. However, an analyst needs to first calculate present value of the returns before using them in the formula of Return on Capital Employed. For this purpose, cash flows need to be discounted using Net Present Value (NPV) method.
- ROCE would not indicate how long is the payback period of a particular investment. For that, payback period method will have to be used. Does not depict what is the payable period.
- Accounting policies may be different for different companies and industries. This may lead to distorted comparison of ROCE. For example, a company may be using revaluation method for its fixed assets while another company may be using cost method. Different methodologies will result in different figures for profit and assets.
- ROCE ratio does not take into account various non-cash factors like depreciation, provisions, amortization etc. More meaningful comparison may be made by calculating EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) ratio.