Ever looked at a business and wondered if they are actually any good at what they do? Not just making sales but truly turning their resources into serious profit?
That’s where Return on Capital Employed or ROCE, comes in.
In this article we will talk about Return on Capital Employed (ROCE), how to calculate it, and how to improve it.
Reach out to one of our professionals to get to know about return on capital employed in the UK. Get in touch with us and you will be provided instant professional help!
Let’s get started!
What is Return on Capital Employed (ROCE)?
Return on capital employed shows how profitable and efficient a company is by indicating how much profit it earns from the total capital invested. A higher ROCE usually means the business is using its resources effectively and generating strong returns on its investments.
How To Calculate Return on Capital Employed (ROCE)?
The basic formula for return on capital employed is: ROCE = EBIT/ Capital Employed. To use this formula, you will need:
- EBIT: It is your operating profit before subtracting interests and taxes.
- Capital Employed: It is the total capital used to generate profits. It can be calculated in two ways:
- Total Assets – Current Liabilities
- Fixed Assets + Working Capital (where Working Capital = Current Assets – Current Liabilities)
What is a Good ROCE Value?
While a higher ROCE is generally better, there is no single “good” value. A strong ROCE is one that is considered favorable relative to the company’s industry, its cost of capital and its historical performance. For general reference, a consistently high ROCE in the 15% to 25% range is often considered a sign of a high-quality business. However, a truly meaningful analysis requires context.
A good ROCE for a car company might be very different from a good ROCE for a software company. The best way to know if a company’s ROCE is good is to compare it with other companies that are just like it.
Also, check the interest rate. Is the company’s return on its money at least double what it has to pay on its loans? If yes, that’s a healthy sign.
Look for improvement too. A company’s ROCE is good if it is getting better over time. That shows the company is becoming more efficient.
Advantages and Disadvantages of ROCE
It is necessary to understand the advantages and disadvantages of ROCE in order to determine how and when to use it.
Advantages of ROCE
- It helps measure efficiency of a company, how effectively its capital is being used to generate profits.
- It is important for comparing the performance of companies of the same industry, especially in capital-intensive sectors.
- Investors use ROCE to assess potential returns on investment and the future profitability of a business.
- It provides a broader, long-term perspective of a company’s financial performance, incorporating debt and other liabilities.
Disadvantages of ROCE
- ROCE is based on historical data and may not accurately reflect future performance, especially after major business changes.
- ROCE figures vary significantly between different industries making comparisons across sectors less useful.
- The large unused cash reserves or significant non-cash assets on the balance sheet can artificially lower a company’s ROCE.
- It does not consider the risk factors associated with different investments, which can lead to an inaccurate assessment of long-term viability.
How To Improve ROCE?
To improve a company’s ROCE, you can do one of two things:
Make More Profit
- Sell more stuff.
- Raise prices (if you can).
- Spend less on making and selling your product.
Use Less Money To Run The Business
- Sell things the company doesn’t use anymore.
- Manage your inventory better so you don’t have so much money tied up in products that just sit on shelves.
- Get customers to pay faster.
ROCE vs. ROIC
Return On Capital Employed (ROCE) is the return that is based on its employed capital, while
Return on Invested Capital (ROIC) is based on the capital invested in the business.
Following are its key differences:
| Aspects | ROCE | ROIC |
| Meaning | It is a broader measure that includes all capital employed in the business, including debt. | It is a more refined, specific measure focusing on the return on invested capital after taxes. |
| Focus | Measures overall financial health and profitability from all capital sources. | Measures the return specifically from the capital that is actively invested and circulating in the business. |
| Numerator | EBIT | Operating Profit after Tax |
| Denominator | Capital Employed | Invested Capital |
Is a High ROCE Good or Bad?
A ROCE that is consistently high is considered good, as it indicates a company is highly profitable and uses its capital efficiently.
Arguments For a High ROCE Being Good
- A higher ROCE means the company is generating more profit for every dollar of capital it uses. It is a sign of a healthy and successful business model.
- A higher ratio suggests that management is effective at allocating resources and making strategic investment decisions.
- Companies that sustain a higher ROCE over time often have durable competitive advantage.
- A high and stable ROCE is often attractive to investors, as it indicates the potential for consistent returns.
Reasons For Cautions When Interpreting ROCE
- ROCE varies significantly according to industries. A good ROCE for a capital-intensive utility company would be considered low for a less capital-intensive tech company.
- A company with large cash reserves can have low ROCE because the cash is included in the capital employed but is not generating returns.
- It can be influenced by accounting methods, like a company might sell old, depreciated assets to reduce its capital employed and artificially boost its ratio.
- Following a long-term trend of stable or rising ROCE is a stronger indicator of a quality business than a single-year spike.
Bottom Line
As a business owner, you have to analyse all the aspects of a higher Return On Capital Employed carefully.
By analysing it carefully, you can make informed decisions that not only improve profitability but also make your business more appealing to investors and shareholders. Over time, this can open doors to new opportunities and sustainable growth.
Need help? Cheap Accountants in London are available to guide you more on VAT on flowers. Stay in touch!
Disclaimer: All the information provided in this article on Return on Capital Employed (ROCE): What It Is and How to Help Improve It, including all the texts and graphics, is general in nature. It does not intend to disregard any of the professional advice.