Return on Capital Employed Calculator (ROCE)
Return on Capital Employed Calculator (ROCE)

Return on Capital Employed Calculator (ROCE)

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What is Return on Capital Employed(ROCE)?

Return on Capital Employed (ROCE) is a financial metric that assesses a company's efficiency in generating profits from its capital. It is calculated by dividing a company's earnings before interest and tax (EBIT) by its capital employed. Capital employed includes both equity and debt.

It provides insight into how well a company utilizes its capital to generate profits. A higher ROCE generally indicates better efficiency in using capital to generate returns. It's a useful measure for evaluating a company's financial performance and the effectiveness of its capital utilization.

What is the formula and methodology of calculating Return on Capital Employed?

The Return on Capital Employed (ROCE) is calculated using the following formula:
ROCE = (EBIT/Capital Employed)

  • EBIT (Earnings Before Interest and Tax) is the operating profit before deducting interest and taxes.
  • Capital Employed is the total capital invested in the business, including both equity and debt. It is usually calculated as the sum of shareholder's equity and long-term debt.

The formula can be broken down into more detailed steps:
  1. Calculate EBIT (Earnings Before Interest and Tax):
    EBIT = Revenue - Operating Expenses

  2. Determine Capital Employed:
    Capital Employed = Shareholder's Equity + Long-term Debt

  3. Apply the ROCE Formula:
    ROCE = (EBIT/Capital Employed)
ROCE is expressed as a percentage and is used to evaluate the efficiency with which a company utilizes its capital to generate profits. A higher ROCE is generally considered favorable, indicating effective capital utilization.
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Why is it important for businesses to understand their Return on Capital Employed?

Understanding Return on Capital Employed (ROCE) is crucial for businesses for several reasons:

  1. Efficiency Measurement: ROCE assesses how efficiently a company utilizes its capital to generate profits. It provides insights into the effectiveness of the company's operations in relation to the capital invested.

  2. Investment Decision: Investors and stakeholders use ROCE as a key metric when making investment decisions. A higher ROCE often suggests a more efficient and profitable use of capital, making the company more attractive to investors.

  3. Comparison with Industry Standards: ROCE allows businesses to compare their performance with industry benchmarks. This comparison helps identify areas where the company may be lagging or excelling in terms of capital efficiency.

  4. Financial Health: ROCE is an indicator of a company's financial health and sustainability. Consistently low ROCE may signal that the company is not effectively utilizing its capital, which could lead to financial challenges in the long run.

  5. Strategic Planning: Understanding ROCE aids in strategic planning. Companies can adjust their business strategies to improve capital efficiency, potentially leading to increased profitability and competitiveness.

  6. Debt Management: For companies with debt, ROCE is crucial in assessing the balance between equity and debt financing. A high ROCE indicates that the company can cover its interest payments effectively, reducing financial risk.

  7. Shareholder Value: ROCE is linked to shareholder value creation. Companies with higher ROCE are more likely to create value for their shareholders, which is a fundamental goal for businesses.

Frequently asked questions

Give an example to showcase Return on Capital Employed(ROCE)

Let's consider a hypothetical company, ABC Ltd, to illustrate the calculation of Return on Capital Employed (ROCE).

  1. Financial Information:
    • Earnings Before Interest and Tax (EBIT): $500,000
    • Shareholder's Equity: $2,000,000
    • Long-term Debt: $1,000,000

  2. Calculate Capital Employed:
    • Capital Employed = Shareholder's Equity + Long-term Debt
    • Capital Employed = $2,000,000 + $1,000,000 = $3,000,000

  3. Apply the ROCE Formula:
    • ROCE = (EBIT/Capital Employed)
    • ROCE = $500,000/$3,000,000

  4. Calculate ROCE:
    • ROCE = approx 0.1667

  5. Convert to Percentage:
    • ROCE = approx 16.67%
In this example, ABC Ltd has a Return on Capital Employed of approximately 16.67%. This means that for every $1 of capital employed, the company generates $0.1667 in operating profits. A higher ROCE would generally be considered favorable, indicating efficient use of capital to generate profits.

The assessment of what constitutes a "good" Return on Capital Employed (ROCE) can vary across industries and is influenced by factors such as the company's business model, capital structure, and economic conditions. However, as a general guideline:

  • Industry Comparison: Comparing a company's ROCE to the average for its industry is crucial. Different industries have different capital requirements and profitability norms. A ROCE that is above the industry average may be considered good.

  • Consistency: Consistency in ROCE over time is valuable. A company with a stable or increasing ROCE over several periods suggests sustained efficiency in capital utilization.

  • Cost of Capital: ROCE should ideally be higher than the company's cost of capital. If ROCE is lower than the cost of capital, it may indicate that the company is not generating sufficient returns to compensate for the risk associated with its capital structure.

  • Investor Expectations: Investors often have expectations for returns based on the risk associated with a particular investment. A good ROCE should align with these expectations and provide investors with confidence in the company's ability to generate profits.

  • Company Goals: A good ROCE is also relative to a company's strategic goals. Some companies may prioritize growth over immediate high returns, while others may focus on maximizing profitability.

  • Economic Conditions: Economic conditions can impact what is considered a good ROCE. During economic downturns, achieving a high ROCE might be more challenging, and expectations may be adjusted accordingly.

There isn't a universally defined "good" ROCE, as it depends on various factors. It's essential for businesses and investors to consider industry benchmarks, historical performance, and the company's specific circumstances when evaluating ROCE.

Increasing a company's Return on Capital Employed (ROCE) involves improving the efficiency with which capital is utilized to generate profits. Here are several strategies that businesses can consider:

  1. Operational Efficiency: Enhance operational efficiency to increase profitability. Streamline processes, reduce waste, and optimize resource utilization to improve the return generated from operations.

  2. Cost Management: Implement effective cost management strategies to control expenses. Identifying and reducing unnecessary costs can contribute to higher earnings and, consequently, an improved ROCE.

  3. Asset Utilization: Maximize the utilization of assets to generate revenue. This includes managing inventory levels, improving production efficiency, and ensuring that assets are deployed effectively to contribute to the company's profitability.

  4. Working Capital Management: Efficiently manage working capital by optimizing the balance between receivables, payables, and inventory. This can free up capital for other productive uses and positively impact ROCE.

  5. Debt Optimization: If the company has debt, optimizing the capital structure can improve ROCE. This involves considering the cost of debt and ensuring that borrowed funds are used judiciously to generate returns that exceed the cost of capital.

  6. Strategic Investments: Evaluate and make strategic investments that have the potential to generate high returns. This could include entering new markets, introducing innovative products, or investing in technologies that enhance operational efficiency.

  7. Revenue Growth: While managing costs is crucial, increasing revenue is equally important. Implement growth strategies that align with the company's objectives, such as expanding the customer base, entering new markets, or diversifying product offerings.

  8. Focus on Profit Margins: Improving profit margins by increasing selling prices, negotiating better supplier deals, or introducing higher-margin products can positively impact ROCE.

  9. Employee Productivity: Invest in employee training and development to enhance skills and productivity. A more skilled and efficient workforce can contribute to improved overall company performance.

  10. Continuous Monitoring and Adjustments: Regularly monitor financial performance and make adjustments as needed. Market conditions, industry trends, and internal factors may change, requiring ongoing strategic adjustments.

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