Return on capital employed definition
/What is Return on Capital Employed?
The return on capital employed (ROCE) measures the efficiency of capital usage in generating earnings. For a company to remain in operation over the long term, its return on capital employed should be higher than its cost of capital; otherwise, continuing operations gradually reduce the earnings available to shareholders. It is commonly used by investors to compare the efficiency of capital usage of businesses within the same industry. Investors tend to bid up the prices of businesses that have a consistent or increasing ROCE, and are less interested in those with a highly variable or declining ROCE.
The return on capital employed is a better measurement than return on equity, because ROCE shows how well a company is using both its equity and debt to generate a return.
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How to Calculate Return on Capital Employed
Both the numerator and denominator of the return on capital employed are subject to a variety of definitions. The main elements are:
Numerator. This is most commonly earnings before interest and taxes, though you can also strip out any earnings from investments, in order to focus more clearly on the return from operations.
Denominator. This is total assets minus current liabilities. It is essentially all of stockholders' equity plus debt.
The ROCE formula is:
Earnings before interest and taxes ÷ (Total assets - Current liabilities)
The measure should be tracked on at least an annual basis and plotted on a trend line, to spot long-term changes in corporate performance.
Example of Return on Capital Employed
Bovey Corporation has earnings before interest and taxes of $500,000, total assets of $4,500,000, and current liabilities of $200,000. Bovey's return on capital employed is:
$500,000 EBIT ÷ ($4,500,000 Assets - $200,000 Current liabilities)
= 11.6% Return on capital employed
A variation on the formula is to use average assets and average current liabilities in the denominator, which avoids any month-end spikes in these figures that might otherwise appear in the calculation.
Problems with the Return on Capital Employed
There are several problems with the return on capital concept, which are noted below:
Skewed by depreciation and impairment. The denominator includes all assets, which means that it includes both fixed assets and their associated accumulated depreciation. Thus, the amount of the denominator will decline over time and yield a higher ratio, unless a company is constantly refreshing its fixed assets with additional purchases. This problem is exacerbated if a company uses accelerated depreciation; when this is the case, a labor-intensive alternative is to convert the depreciation to the straight-line basis and then run the return on capital employed calculation. The denominator can also be skewed downward if a company records the impairment of its fixed assets.
Skewed by the age of the business. The net effect of the preceding depreciation and impairment issues is that an older business tends to have a smaller denominator in the calculation, which results in a higher return on capital employed than a newer business that has not had more time in which to depreciate or record the impairment of its assets.
Inconsistency of calculation. There are a wide range of interpretations on how the return on capital employed is to be calculated, so be sure to consistently use the same formula when using it for trend analysis, or in comparison to the results of competitors.
Does not factor in risk. The measurement does not factor in the risk associated with the returns being generated. This means that a business might report a high return on capital employed, but is operating in an industry in which the risk level is very high; this may result in extreme variability in the returns generated.
Is based on historical results. The measurement does not address projected future returns, which may differ substantially from what the business generated in the past.