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 Return on Capital Employed
The ROCE formula is shown below.
In the ROCE formula the terms have the following meanings.
- Earnings before interest and tax (EBIT) is from the income statement. It is sometimes referred to as profit before interest and tax (PBIT).
- Capital Employed is from the balance sheet and includes total assets less current liabilities.
How to Calculate the ROCE
To illustrate, the income statement and balance sheet below are used together with the ROCE formula to calculate the return on capital employed.
| Revenue | 440,000 |
| Cost of sales | 176,000 |
| Gross margin | 264,000 |
| Operating expenses | 135,000 |
| EBITDA | 129,000 |
| Depreciation | 65,000 |
| Earnings before interest and tax | 64,000 |
| Interest | 20,000 |
| Income before tax | 44,000 |
| Tax | 9,000 |
| Net income | 35,000 |
| Cash | 5,000 |
| Accounts receivable | 95,000 |
| Inventories | 50,000 |
| Current assets | 150,000 |
| Property | 390,000 |
| Fixed assets | 390,000 |
| Total assets | 540,000 |
| Accounts payable | 90,000 |
| Other liabilities | 10,000 |
| Bank overdraft | 20,000 |
| Current liabilities | 120,000 |
| Long term debt | 190,000 |
| Total liabilities | 310,000 |
| Capital | 60,000 |
| Retained earnings | 170,000 |
| Total equity | 230,000 |
| 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 formula calculates the return on capital employed 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. In contrast, 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 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. Therefore to make comparisons you need to use a comparable business operating in your sector.
- The 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.