ROCE

What it means

ROCE, return on capital employed, measures the operating profit a company generates from the capital it has permanently committed to the business. It is calculated as EBIT divided by capital employed, defined as equity plus long-term borrowing, or as total assets less current liabilities.

The advantage of ROCE is that the numerator is profit before interest and tax while the denominator includes capital from both owners and lenders. The ratio is therefore not affected by how the company is financed. It allows the returns of companies with different capital structures to be compared, which ROE cannot do, since ROE also rises with higher leverage.

ROCE is close to ROIC. The difference is mainly that ROIC usually works with after-tax profit and invested capital excluding surplus cash, while ROCE uses EBIT and a broader definition of capital. In practice both are used to judge whether a company earns more than its capital costs.

How it works in practice

The key comparison is ROCE against the cost of capital, such as WACC. If ROCE is persistently higher, the company creates value and further investment in it makes sense. If lower, the capital would earn more elsewhere, and causes should be sought, such as low margins, underused assets or excess inventory.

In analysis ROCE is broken down into EBIT margin and capital turnover. A company can improve ROCE either through a higher margin or through better use of assets, for example selling surplus machinery, reducing stock or shortening debtor days. The breakdown shows which route is more realistic for a particular company.

Banks and investors use ROCE to compare companies within an industry and when deciding on financing. For owners it is useful to watch the trend: falling ROCE alongside rising revenue may mean growth is expensive and consumes more capital than it generates in profit.

What to watch out for

The result is strongly affected by the book value of assets. A company with old, largely depreciated assets shows high ROCE even though its assets will soon need replacing. When comparing companies, consider asset age, differences in depreciation and whether assets are owned or leased.

Beware of one-off items in EBIT, such as asset sales or exceptional costs, and seasonal swings in capital. It is advisable to use average capital for the year and adjusted EBIT. Otherwise a single year's ROCE can give a distorted picture that does not reflect long-term performance.