Return on capital employed (ROCE) ratio

Definition of Return on Capital Employed

Return on capital employed (ROCE) ratio is calculated by expressing profit before interest and tax as a percentage of total capital employed. This ratio aims at showing how well a company has used its total long term funds. A high return on the capital employed ratio is the indication of efficient use of the funds invested in the business.

Explanation

The capital employed has been worked out by deducting current liabilities from the total assets. The return on capital employed indicates how the management has used the funds supplied by creditors and owners. The higher the ratio, the more efficient the company in using funds entrusted to it. This ratio represents the interests of the owners and the long-term

This is often abbreviated to ROCE and sometimes given the alternative name “Return on investment” or ROI. It is profit expressed as a percentage of the net value of the money invested in the business. Many people believe that it is the most important of the accounting ratios.


Capital employed is the balance sheet total, which in the case of a company is share capital plus reserves. This is the ‘shareholders’ fund’, which is the same as assets less liabilities. Sometimes profit before tax is used and sometimes profit after tax is used. Exceptional items may be included or excluded and so may interest. Profit after interest and after tax is the most commonly used figure.

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Normally, the profit for the year is compared with capital employed, as shown in the balance sheet at the end of the year. however, it is better (though in practice perhaps unnecessary) to use the average capital employed throughout the year. To obtain this you will need at least the opening and closing balance sheets.

There are two way to improve the return on capital employed. The obvious one is to improve the profit, but an alternative is to reduce the capital employed. This can be illustrated by showing the two ways that costwold Components plc might have achieved a return on capital employed of 60%.

Method 1 – by increasing the profit

$000
Profit after tax3,581
Capital employed5,968
ROCE60%

Method 2 – by reducing the capital employed

$000
Profit after tax3,015
Capital employed5,025
ROCE60%

Formula of Return on Capital Employed

Return of Capital Employed - Formula

Profit before interest and tax is also termed as earnings before interest and tax or EBIT.


Capital employed is the amount of total long term funds at the disposal of the company i.e., it is the sum of equity, preference share capital and long term loans. A general approach to calculating capital employed from a given balance sheet is to deduct current liabilities from the total assets of the business. It can be expressed in the form of the following equation:

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Capital employed = Total assets – Current liabilities

Note for students: It is a general practice to use average capital employed (i.e., capital employed at the beginning of the year plus capital employed at the end of the year divided by two) as the denominator of the formula. However, if capital employed at the beginning of the year is unknown or cannot be determined from the available data, it is not uncommon to use only the year-end figures to calculate capital employed.

Example

The John trading concern gives you the following information at the end of year 2016:

Total assets: $2,400,000
Fixed assets: $800,000
Current assets: $1,600,000
Current liabilities: $876,000
Profit before interest and tax: $500,000

Calculate return on capital employed ratio from the above information.

Solution

Return on capital employed ratio = (Net profit before interest and tax/Capital employed) × 100
=  ($500,000/$1,524,000*) × 100
= 32.81%

*Capital employed = Total assets – current liabilities
= $2,400,000 – 876,000
= $1,524,000

The John Trading Concern has a 32.81% return on its total capital employed in the business. In other words, each dollar invested in the business generates a $0.3281 of profit before interest and tax. The parties interested to know the efficiency of the management in fund utilization may compare this ratio with the industry’s average return on capital employed ratio.

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