Return on capital employed (ROCE) is a profit ratio to measure and gauge the financial productivity of a business. This measure helps you to know how a business is utilizing its capital to generate profit. The higher ROCE shows the better profitability ratio of your business. It’s one of the important KPIs for investors to know the profit margin of a company.
Let’s find out how to measure financial productivity with ROCE and how to improve it!
How to measure the financial productivity with ROCE?
To measure ROCE, you need to divide earnings before interest and tax (EBIT) with the total capital employed (Total assets – current liabilities):
- Earnings before interest and tax (EBIT) is the profit of the company with all expenses excluding interest and tax expenses.
- Capital Employed is the total capital/equity investment in a business. It is commonly measured by deducting current liabilities with the total asset.
Return on capital employed is used to show how much capital is required to generate more profit. Capital also includes shareholders’ equity, debt, and retained earnings. If a company has high retained earning, it is considered effective for its further expansion.
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How to Improve Return on Capital Employed?
There are different ways to improve the return on capital employed. Here are some ways to do it:
1) Reduce Costs and Increase Sales
If you reduce the cost of your products, you can raise your sales ultimately heading you towards more profit. To do it, you don’t need to spend less amount on your products rather you need to find out the nature of the cost and its effects on the selling price of the product and its profits. The reduction in the cost will also improve the operational efficiency of the company.
On the other hand, reducing the selling price won’t be a viable solution if your cost of the products is not reduced. You must also note that higher sales don’t always guarantee a higher profit or returns.
Therefore, you need to analyse how much price reduction affects the sales percentage and examine the increase in profit by reducing the cost percentage. By combining both the reduction of the price and boosting up your sales will provide a good return on capital.
2) Selling Unnecessary Assets
Your business might contain some unnecessary or unprofitable assets. Selling assets like machinery and other assets that have surpassed their useful life can improve the ROCE. Removing the unnecessary asset would lead to the usage of less capital against the same amount of production.
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3) Paying off debt
By paying off your debt you’ll reduce your liabilities that will lead to the improvement of the ROCE ratio. Other ways for improving ROCE is to restructure existing debts, refinancing with reduced interest rate and with more flexible repayment terms.
4) Level of Operation:
The level of operation is also a great factor that can affect the return on capital. A small-scale business will have a fixed cost that will result in a lower return. On the contrary, a large-scale business contains a higher volume of products that can bring down the fixed cost. This practice, known as economies of scale, is a great way for generating more profit.
To conclude, we have discussed the most effective ways to increase the return on capital employed (ROCE). As a company owner, you need to analyze every aspect carefully for a higher ROCE. With this, your company will attract a large number of investors and shareholders that will lead it towards further expansion.
Along with finding the profitability ratio with ROCE, you need to efficiently operate your business. As if your business does not operate efficiently, it’d be considered a loss rather than a profit.
Disclaimer: This blog is intended for general information on ROCE.