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Return on Capital Employed (ROCE), Its Utility and Limitations

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There are many financial ratios which tell us the profitability of a company. Return on Capital Employed (ROCE) is one such ratio which gives us an idea about the profitability and capital efficiency of a company.

Return on Capital Employed (ROCE) is nothing but the parameter which demonstrates, how well a company is capable of generating profits from the capital it is having. It is useful for the shareholders, investors and financial managers who use this ratio to analyze the profitability of a company.

How to Calculate the Return on Capital Employed (ROCE) of a Company?

Return on Capital Employed (ROCE)= EBIT/ Capital Employed

Where EBIT= Earnings before interest and tax

EBIT is the profit of company which includes all expenses minus interest and tax expanses. It shows the company’s total income before cost deductions and it can be find in the profit and loss statement of the company.

Capital Employed= Total Assets of the Company- Current Liabilities

Or

Capital Employed= Fixed Assets+ Working Capital

The capital employed is the net amount of equity that is invested in the company.

In other words, it is the sum of total equity and total debt of the company.

Example:

Let us assume that a company X has EBIT = ₹ 250 Crores

Company Y has EBIT = ₹ 200 Crores

Which company seems better? You will say that the company X is better as it has higher EBIT. However, it is always good to compare based on ROCE to analyze which is better company.

Suppose the capital of company X is Rs. 500 Crores and the capital of company Y is Rs. 350 Crores.

ROCE of company X= 250/500= 0.5

ROCE of company Y = 200/350= 0.57

In this scenario, the company Y is a better investment because it is having higher ROCE.

Significance of ROCE

ROCE, or Return on Capital Employed, is a financial metric that is widely used by businesses, investors, and analysts to assess a company’s profitability and efficiency in utilizing its capital resources. Its significance lies in its ability to provide valuable insights into a company’s financial performance and its ability to generate returns for its investors. Here are some key points on the significance of ROCE:

Profitability Assessment

ROCE measures the profitability of a company by considering both its operating income and the capital employed in its operations. It helps in evaluating whether a company is generating an adequate return on the investments made in its business.

Efficiency Indicator

ROCE indicates how efficiently a company is using its capital. A higher ROCE generally suggests that the company is using its capital more efficiently to generate profits, which can be an attractive attribute for investors.

Comparability

ROCE is a useful tool for comparing the performance of different companies, especially those in the same industry. It provides a standardized metric to assess how effectively companies in the same sector are using their capital to generate returns.

Long-term Sustainability

A consistently high ROCE is a positive sign, as it indicates a company’s ability to sustain its profitability over the long term. Companies with strong ROCE may have a competitive advantage in their industry.

Investment Decision-Making

Investors use ROCE to evaluate the financial health of a company and make informed investment decisions. A high ROCE can be an indicator of a well-managed company, while a declining or low ROCE may raise concerns.

Capital Allocation

Companies can use ROCE as a guide for making decisions about capital allocation. It can help management determine which projects or investments are likely to generate the highest returns, thereby optimizing resource utilization.

Risk Assessment

ROCE can also be an important risk assessment tool. Companies with low or negative ROCE may be at risk of financial instability or bankruptcy, as they may not be generating enough returns to cover their capital costs.

Improvement Measurement

Companies can use ROCE as a benchmark to track their financial performance over time. By comparing current ROCE to historical data, a company can assess whether its financial management and operational efficiency are improving or deteriorating.

ROCE is a significant financial metric that helps assess a company’s profitability, efficiency, and overall financial health. It is a valuable tool for both investors and businesses to make informed decisions, allocate capital effectively, and evaluate long-term sustainability.

Limitations of ROCE

Here are some of the key limitations of ROCE:

Industry Variations

Different industries have varying capital requirements and cost structures. ROCE may not be directly comparable between industries, making it challenging to assess performance across diverse sectors.

Inaccurate Valuation

ROCE is based on book values, which may not accurately represent the true market values of assets and liabilities. This can lead to discrepancies, especially in companies with a significant gap between book value and market value.

Non-Consideration of Timing

ROCE does not take into account the timing of investments or returns. A project that generates returns quickly may have a lower ROCE than a longer-term project, even if the latter is more profitable in the long run.

Capital Structure Ignored

ROCE does not consider a company’s capital structure (the mix of debt and equity). Companies that rely heavily on debt may have high ROCE due to financial leverage, but this can also increase financial risk.

Lack of Insight into Profit Margins

ROCE is focused on capital efficiency and does not directly measure profit margins. A company with a low-profit margin can still have a high ROCE if it uses a lot of capital.

Not Accounting for Economic Conditions

Economic conditions, interest rates, and industry cycles can significantly impact ROCE. A company’s ROCE may be influenced by external factors beyond its control.

Incomplete View of Risk

ROCE does not provide a comprehensive view of risk. A company may have a high ROCE, but it might be taking on excessive risk to achieve those returns, which could be unsustainable in the long term.

Dependent on Accounting Methods

ROCE relies on accounting metrics, which can be manipulated or subject to variations in accounting standards. This can make it challenging to compare ROCE between companies or over time.

No Consideration of Taxation

ROCE does not account for the effects of taxation, which can vary widely between jurisdictions and impact a company’s true return on capital.

Short-Term Focus

ROCE is typically calculated for a specific period, such as a year. This short-term focus may not capture the long-term sustainability of a company’s profitability.

While ROCE is a useful metric for assessing a company’s profitability and capital efficiency, it should be used in conjunction with other financial metrics and considered in the context of a company’s specific circumstances and industry. Its limitations highlight the importance of using a variety of tools and measures to gain a more comprehensive understanding of a company’s financial health and performance.

Difference between ROCE and (Return on Equity) ROE

The main difference between ROCE and ROE is that ROE is the return a company generates on its equity capital. It does not consider borrowed capital. ROCE is the return a company generates on its equity as well as borrowed money.

ROCE is a better parameter to analyze the performance of the company as it focuses on how well a company utilizes its equity as well as borrowed money.

Please note that ROCE is not appropriate to analyze the finance companies as their business is based on leverage(debt). Return on Assets (ROA) is a better parameter to measure the performance of the company in this case.

Conclusion

ROCE is a financial parameter which is used to access the performance of a company. It tells us about how well and efficient a company is in managing its own money as well as borrowed money. More the ROCE, better is the performance of the company. Many investors prefer investing in companies with ROCE > 20% over the past five years.  You should be careful to compare the ROCE of companies within the same industry as those from different sectors tend to have varying ratios.

Also read: Internal Rate of Return (IRR): Uses, Examples and Limitations

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Rajesh Pant
Rajesh Panthttps://managemententhusiast.com
My name is Rajesh Pant. I am M. Tech. (Civil Engineering) and M. B. A. (Infrastructure Management). I have gained knowledge of contract management, procurement & project management while I handled various infrastructure projects as Executive Engineer/ Procurement & Contract Management Expert in Govt. Sector. I also have exposure of handling projects financed by multi-lateral organizations like the World Bank Projects. During my MBA studies I developed interest in management concepts.
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