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Return of Capital Employed Ratio (ROCE)

In profitability ratios return on capital employed is the most comprehensive and meaningful ratio. We may say

that ROCE is the primary measure of profitability and other profitability ratios are studied together with ROCE for detail analysis as to why ROCE changed.

FORMULA

Return On Capital Employed  =

Earnings Before Interest and Tax


Total Capital Employed

EXAMPLE

Earnings before interest can be extracted directly from face of Statement of Comprehensive Income. Total capital employed we know is the investment in the form of long term loans by lenders and in the form of shares by the shareholders. Therefore this can be extracted from the face of Statement of Financial Positions form Shareholders’ Equity Section and Non Current Assets section.

Return On Capital Employed  =

900,350


3,743,995 + 1,182,670

Return On Capital Employed  =

18.27 %

 

Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).

MEASUREMENT UNIT

ROCE ratio is measured in Percentages.
Using the above example, 1$ of capital employed (funds in the form of shares as well as long term borrowings) has earned 18.27%.

INTERPRETATION


How to interpret the ratio


Funds are required by management for running business. Normally funds are arranged either through equity (shareholders) or long term borrowings (lenders). Since shareholders or lenders have made investment in the business they are interested in earnings generated by business so that they can have reasonable return on their investment. ROCE is the ratio which gives information that how much 1$ of capital employed has earned.

Logically ROCE can be improved only if numerator of the ratio i.e. earnings before interest and tax increases. An increase in earnings may be from any of the following reasons:

  • Profits margin are increased by the management on sales. This will lead to selling the same quantity with higher price thus overall an increase in sales revenue which will result in improved ROCE.
  • On the other hand, an increased efficiency with which assets are used for generating profits can result in the reduction of cost of sales thus increasing the overall earnings.

Therefore, ROCE when studied in detail after breaking into several other ratios gives better insights (future pages provide the details of such ratios).
ROCE therefore should be studied using

  • Profit Margin ratios
  • Assets utilization ratio (this topic is covered and part of efficiency ratios)

 

Users’ needs addressed by the ratio


Shareholders are most common users of profitability ratios as they have invested in the company for earning return in the form of dividends which are distributed from the profits generated by the management during the year (the more the profits, the more the dividend).

Lenders are also interested as they have forwarded the long term loan to company and they want to ensure that company can pay yearly interest as well as principal back to lenders.

Management monitors the ROCE to control its performance since management is primarily responsible for using the assets of the company with great efficiency for generating sufficient profits. This ratio tells management where they are standing at the moment and what they should do to improve it.

(You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).

 

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