How efficiently a company turns capital into profit is a good indicator of how well it is operating. Return on capital employed (ROCE) is a financial ratio used by business owners, shareholders, and potential investors to assess the profitability of a business.
This article explores why and how to calculate ROCE, as well as which businesses and circumstances the measure is most suitable for, and how to improve it.
Return on capital employed meaning
Imagine you’re an investor, comparing the profitability of two businesses that both sell candles. Business A generates profits of £20,000, while business B generates profits of £30,000. Business B appears more successful, but has invested three times as much capital as business A to achieve its profits.
As an investor, the ROCE metric is powerful as it allows you to assess both profitability and the efficiency of capital used to generate that profit.
Return on capital employed formula
The formula for calculating ROCE is:
ROCE = EBIT/ Capital Employed
- EBIT is earnings before interest and tax.
- Capital employed is the total equity invested in a business.
This can be calculated using one of two formulas:
Capital Employed = Total Assets – Current Liabilities
Or
Capital Employed = Fixed Assets + Working Capital
What is a good ROCE value?
Since it reflects the profitability of a business, the higher the ROCE value, the better. A rule of thumb is that you should be aiming for a ROCE of at least 15%, but the averages differ from industry to industry, so how well you’re doing depends on what sector you’re in. In manufacturing, ROCE can exceed 25%, whereas in retail it typically ranges from 5% to 15%.
In order to generate value for shareholders, a business should be looking to generate a ROCE that is consistently more than its weighted average cost of capital (WACC). In other words, it needs to make a bigger return on the money spent funding the business than the average cost of that funding (from both debt and equity).
What does a low ROCE mean?
A low ROCE indicates that a company is not using its capital efficiently and is not generating a high return on its investment.
How to improve ROCE
Jennifer Brown, managing director of leather goods company Pampeano, monitors her business’s ROCE and has used the findings to reduce inefficient spending.
“I’ve cut costs, notably speculative spend on social media channels that weren’t generating positive return,” she says. She has also reworked shipping operations in a way that allows her to benefit from volume discounts, and negotiated better terms with suppliers.
Brown has also looked to improve ROCE by diverting capital towards her bestselling products. “We did a massive stock analysis and forecast sales by SKU (stock keeping unit)," she says.
“Our top sellers have an inventory turnover of more than 10, which is a problem. We don’t have enough of those products, so we need to look at how to get money out of stock that turns over slower and invest it in our top sellers.”
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Advantages and disadvantages of ROCE
Advantages of ROCE
The key benefit of ROCE is that it allows a comparison of profitability relative to both equity and debt. It is also valuable in comparing companies of similar scale that operate within the same industry.
Disadvantages of ROCE
ROCE can be misleading when comparing businesses operating in different industries. It also has limitations as a single metric as it focuses solely on use of capital. For that reason, it is often best used in combination with other metrics.
Alastair Barlow, CEO and co-founder of the finance app Flinder, believes the value of ROCE is dependent on your business and what you’re trying to learn. While some businesses, like Pampeano, use it to streamline operations, others may be more likely to use it to make themselves more attractive to investors than as a day-to-day measure. Barlow believes the metric is of most use to investors, rather than SMEs themselves.
“I would advise business owners to use metrics that are more aligned to trading profitability, growth, cash and operational indicators such as sales activity, pipeline and NPS (net promoter score),” he says.
But if you are trying to gauge the attractiveness of your business to investors, then ROCE is a useful metric to be aware of.
ROCE vs ROIC
ROCE and Return on Capital Invested may sound similar, but where ROCE measures the return on capital employed, ROIC measures the return on invested capital (or capital invested). These are different attributes.
ROIC = Operating profit after tax/ average invested capital
ROIC is much more akin to measuring the return an investor or debt lender gets on the cash they have invested. ROCE meanwhile is more relevant if you’re deploying capital and have multiple options on how and where to deploy it, and want to compare the return you get from each option.
NOPAT vs EBIT
NOPAT (Net operating profit after tax) and EBIT are often confused for one another by business owners, but are different measures. Both are used to compare two or more businesses that operate in the same industry, but while EBIT is calculated by subtracting operating expenses from revenue and adding non-operating income, and doesn’t take tax and interest into account, NOPAT measures operating profits after taxes.
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