Return on capital employed, or ROCE for short, is particularly useful when comparing the performance of companies in capital-intensive sectors such as utilities and telecommunications, but it is also an effective metric for other sectors such as the subscription business.
This is because, unlike return on equity (ROE), which only analyzes profitability in terms of a company’s usual equity, Return on capital employed also takes into account debt and other liabilities. This provides a better indication of the financial performance of companies with significant debt.
For a company, ROCE performance over years is also an important KPI. In general, investors tend to favor companies with stable and increasing Return on capital employed figures over companies whose ROCE is volatile.
How to calculate ROCE?
Return on capital employed is a financial measure of a company’s profitability and the efficiency with which capital is employed. The calculation of ROCE:
Formula of ROCE
“Capital employed” is the sum of equity and debt capital; it can be simplified as (total assets – current liabilities). Rather than using capital employed at any point in time, analysts and investors generally calculate ROCE based on “average capital employed,” which is the average of capital employed at the beginning and end of the period.
An ROCE example for a better understanding
Return on capital employed is a useful metric for comparing the profitability of companies based on the capital they employ. For example, consider two companies, Gamma and Delta, which operate in the same sector, namely the subscription business.
Gamma has an EBIT of EUR 5 million, on revenues of EUR 100 million in a given year, while Delta has an EBIT of EUR 7.5 million on revenues of EUR 100 million in the same year.
Looking at these numbers, it may seem that Delta should be the top investment as it has an EBIT margin of 7.5% compared to 5% for Gamma.
But before making an investment decision, you have to look at the capital employed by both companies. So let’s assume that Gamma has a total capital of 25 million euros and Delta has a total capital of 50 million euros.
In this case, Gamma’s ROCE is 20% higher than Delta’s ROCE of 15%, which in result means that Gamma uses its capital better than Delta.
Fundamentals of the ROCE definition
The higher the percentage of this indicator of a company, the better for its shareholders, because a high ROCE means that the company uses its capital more efficiently. Therefore, the analysis of this ratio by different companies is a way for investors to compare companies and then decide in which company they want to invest their resources.
Analyzing the track record of this indicator against a company over the years to understand its fluctuations over time is also a good way to evaluate a company. Ideally, this ratio should remain stable or show growth over the years.
However, it is always important to remember that “return on capital employed” should never be analyzed in isolation, but rather the entire economy (macroeconomics, segment, competitors, growth trends, evolution of return on assets, net worth, profit, among others) of the company in question.
Conclusion: ROCE is an important comparison metric for investments in companies in the same sector
Return on Capital employed is an indicator that says a lot about companies, especially those operating in the same sector. Return on capital employed shows how much operating income is generated for each euro of capital invested.
A higher Return on capital employed is always more favorable, as it indicates that more profits are generated per euro of capital employed. As with any other financial equation, however, it is not enough to calculate only a company’s ROCE. Other profitability ratios, such as return on assets, ROI and return on equity, should be used in combination with ROCE to determine whether or not a company is likely to be a good investment.
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