Return on capital employed (ROCE)

In simple terms

A business is funded by two groups: shareholders, who provide equity, and lenders, who provide debt. Return on capital employed (ROCE) measures the return the business earns on all of that money together, before deciding how to split it between them.

Some analysts use total assets minus current liabilities instead, which gives a similar but not identical figure. What matters is using the same definition when you compare.

Operating profit, also called EBIT (earnings before interest and tax), is the profit available to pay both lenders and shareholders. Dividing it by the capital both groups provided gives a return on the whole business.

Why ROCE is less distorted by debt

The ROE lesson showed that borrowing can raise return on equity, because equity shrinks while profit stays roughly the same. ROCE avoids most of this, because both the numerator and the denominator include the lenders' share.

So ROCE is the better measure for comparing the underlying quality of businesses with different amounts of debt.

ROCE and the cost of capital

Lenders and shareholders expect a return on their money. The weighted return they require is the cost of capital, explained in the WACC lesson. A business creates value for its owners only when it earns more on its capital than that cost.

• ROCE above the cost of capital: each rupee invested produces more than it costs, so growth adds value.
• ROCE below the cost of capital: the business destroys value, and growing it destroys more. Investors would be better off with the money invested elsewhere at the same risk.

A business with a consistently high ROCE, well above its cost of capital, often has a competitive advantage. Without one, competition tends to push ROCE down towards the cost of capital over time.

Adjusting for cash and one-offs

Some companies hold large cash balances they do not need to run the business. Cash earns little, so it lowers ROCE. Analysts often calculate ROCE on capital employed excluding surplus cash to see the return on the operating business, sometimes called return on invested capital.

Similarly, remove one-off gains and losses from EBIT, and use average capital employed over the year when capital has changed a lot.

Comparing ROCE

• Over time: a rising ROCE suggests improving efficiency or pricing; a falling one may signal competition or poor investments.
• Against peers: compare with companies in the same industry, because capital intensity varies widely.
• Through the cycle: for cyclical businesses, average ROCE across a full cycle.

Why it matters

ROCE is one of the most useful single measures of business quality, because it shows how well a company turns capital into profit regardless of how it is financed. Combined with growth, it tells you whether a company's expansion is creating value. Valuations that assume high growth make sense only if the company earns returns above its cost of capital on the money it invests.

Limitations

ROCE depends on book values, which reflect historical costs: an old, fully depreciated plant can make ROCE look high even if replacing it would be expensive. Acquisitions add goodwill, which raises capital employed. Definitions also vary between analysts, so check how a quoted ROCE was calculated before comparing.

Common mistakes

• Using ROE to compare companies with very different debt levels. Use ROCE as well.
• Ignoring surplus cash, which can hide a very profitable business behind a modest ROCE.
• Comparing ROCE across industries with very different capital needs.
• Forgetting the cost of capital. A positive ROCE is not enough; it must exceed what capital costs.

Try it yourself

Choose a listed company and use its annual report.

1. Find EBIT, or calculate it as profit before tax plus finance costs.
2. Calculate capital employed as equity plus borrowings, using the average of opening and closing figures.
3. Calculate ROCE, then recalculate excluding cash and investments not needed for operations.
4. Compare with ROE. Which is higher, and why?