What is ROCE – Return on Capital Employed?
ROCE or return on capital employed measures the percentage rate of return a business gets on its capital employed. It is calculated by dividing the earnings before interest and tax by the total assets less current liabilities of the business.
Formula for ROCE – Return on Capital Employed
- Earnings before interest and tax (EBIT) is shown in the income statement. It is sometimes referred to as profit before interest and tax (PBIT).
- Capital Employed is found in the balance sheet and includes total assets less current liabilities.
How to Calculate the ROCE
|Cost of sales||176,000|
|Earnings before interest and tax||64,000|
|Income before tax||44,000|
|Long term debt||190,000|
|Total liabilities and equity||540,000|
In the example above, from the income statement the earnings before interest and tax is 64,000, and from the balance sheet, the total assets are 540,000, and the current liabilities are 120,000.
The ROCE (return on capital employed) is given as follows
ROCE = Earnings before interest and tax / (Total assets - Current liabilities) ROCE = 64,000 / (540,000 - 120,000) ROCE = 15.24%
The bank overdraft has been included as it is considered to be a current liability. The bank and other loans have been assumed to be long term.
From the balance sheet above, it should be noted that the total assets less current liabilities is equal to the equity plus long term liabilities, so that ROCE can also be defined as follows:
Return on Capital Employed (ROCE) Interpretation
The ROCE is considered to be a fundamental financial ratio for a business. It measures the ability of a business to use its money to generate earnings.
Interest is specifically excluded from the calculation by the use of earnings before interest and tax as the amount of interest paid depends on the amount of debt and therefore the capital injected by the owners. If interest was included it would distort the ROCE calculation and make it impossible to make comparisons with another business funded in a different manner.
Useful tips for Using the ROCE
- The ROCE (return on capital employed) will vary from industry to industry. To make comparisons you need to use a comparable business operating in your sector.
- The ROCE (return on capital employed) will need to be higher than the return available if the same amount of money was invested in a minimal risk deposit with a bank.
- ROCE should always be higher than the rate at which the business borrows as an increase in borrowing leads to an increase in assets which in turn should give a higher return if the ROCE is at the correct level.