Return on Capital Employed (ROCE) is a financial ratio which is a percentage of return that a company realizes from the capital employed. ROCE gives us the efficiency of the capital utilized to generate earnings.
There are various definitions of the term Return and Capital Employed. These are explained with the help of formulas and examples.
Formula:
ROCE = (EBIT / (Total Assets - Current Liabilities)) * 100
OR
ROCE = (EBIT / Capital Employed) * 100
Explanation of the Numerator and Denominator
EBIT = Earnings Before Interest and Tax also known as Operating Profit.
In certain cases the numerator used is Profit Before Tax. However in most cases EBIT is used as the numerator which seems to be more correct. Profit Before Tax is mainly used to calculate Return On Equity.
Capital Employed = Shareholder's Funds + Long Term Borrowings.
In other words Capital Employed is Total Assets - Current Liabilities, which is also used as the Denominator.
There are different definitions of the term Capital Employed. Thus in some cases it is defined as Total Assets.
In other cases instead of Long Term Borrowing, Total Borrowings are considered. Total Borrowings would include overdraft, short term loans and lease obligations.
Thus, in the formula above current liabilities can also be replaced by non-interest bearing liabilities.
Whether to include Total Borrowings or Long Term Borrowings would depend on the materiality of the value of overdrafts and other interest bearing short term liabilities. Thus if the value of overdraft and other short term borrowings is less then it can be ignored. This also depends on how you interpret the ratio and can be decided on a case to case basis. It is wise to include all Borrowings / Interest bearing liabilities as Capital Employed since EBIT is used in the numerator. Thus the intention is to know the return which is sufficient to bear the interest cost to maximize the shareholder's earnings.
Example 1
Profit and Loss Account for the year ended 31-12-07 (Only Relevant Figures)
Sales - $ 75,000
Operating Profit (EBIT) - $ 15,000
Interest - $ 1,800
Profit Before Tax (PBT) - $ 13,200
Balance Sheet as at 31-12-07
Fixed Assets - $ 125,000
Current Assets - $ 75,000
Total Assets - $ 200,000
Share Capital - $ 100,000
Reserves - $ 25,000
Long Term Loans - $ 25,000
Current Liabilities - $ 50,000
Total Liabilities - $ 200,000
ROCE = (EBIT / Capital Employed) * 100
ROCE = (15,000 / (100,000 + 25,000 + 25,000) * 100
ROCE = 10%
OR
ROCE = (EBIT / (Total Assets - Current Liabilities)) * 100
ROCE = (15,000 / (200,000 - 50,000)) * 100
ROCE = 10%
The ROCE needs to be compared with the Rate of Interest on Bank Borrowings which in this case is between 7% to 8%. Thus any increase in Bank Borrowings with proportionate business growth would still leave a share of 2% to 3% for the shareholders if ROCE is maintained at 10%.
Example 2
Profit and Loss Account for the year ended 31-12-07 (Only Relevant Figures)
Sales - $ 125,000
Operating Profit (EBIT) - $ 20,000
Interest - $ 15,000
Profit Before Tax (PBT) - $ 5,000
Balance Sheet as at 31-12-07
Fixed Assets - $ 175,000
Current Assets - $ 150,000
Total Assets - $ 325,000
Share Capital - $ 75,000
Reserves - $ 25,000
Long Term Loans - $ 100,000
Current Liabilities
Creditors - $ 50,000
Bank Overdraft - $ 75,000
Total Liabilities - $ 325,000
Calculation of ROCE without considering Bank Overdraft
ROCE = (EBIT / Capital Employed) * 100
ROCE = (20,000 / (75,000 + 25,000 + 100,000)) * 100
ROCE = 10%
OR
ROCE = (EBIT / (Total Assets - Current Liabilities)) * 100
ROCE = (20,000 / (325,000 - 125,000)) * 100
ROCE = 10%
Calculation of ROCE considering Bank Overdraft
ROCE = (EBIT / Capital Employed) * 100
ROCE = (20,000 / (75,000 + 25,000 + 100,000 + 75,000)) * 100
ROCE = 7.3%
OR
ROCE = (EBIT / (Total Assets - Non interest bearing liabilities)) * 100
ROCE = (20,000 / (325,000 - 50,000)) * 100
ROCE = 7.3%
The interest rate charged by the Bank is between 8% to 9%. In this case it is better to consider Bank Overdraft in the ROCE calculation, since it gives a more realistic figure of 7.3% on the Capital Employed. Thus any increase in Bank Borrowings either Long Term Loans or Bank Overdraft is going to affect the Shareholder's earnings. It may result in reduction of Shareholder Earnings in case the EBIT growth is proportionate to the growth of Capital Employed when the increase in Capital Employed is mainly by way of increase in Borrowings.
One factor which needs to be considered here is whether there is a sudden increase in the Bank Overdraft towards the end of the Accounting Period for which the ROCE is calculated. If this is the case then it is better to consider the annual average, instead of the year end value. If the annual average is not material then it can be ignored. One way of determining whether the Bank Overdraft is of significant value or not during the year is to analyze the interest (finance cost) incurred during the year and the rate of interest charged by the Bank. In case the interest on the Long Term Borrowings is approximately close to the total interest (finance cost) then it can be assumed that the Bank Overdraft value is not material.
Conclusion
ROCE gives us an indication of how the company is utilizing its capital and whether the company is making enough earnings to cover its cost of capital. The ROCE needs to be compared with other companies in the industry since certain companies are capital intensive and thus may have a lower ROCE.
ROCE also needs to be compared with the interest earned from the Bank. In case interest earned %age is higher than management could consider investing the money in the Bank instead of investing in business.
ROCE earned from one business or one project can be compared with other business / project to increase the investment in the business which gives the best ROCE.
