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Definition, Formula, Example — LiteFinance (ex. LiteForex)

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What should a wise investor consider when choosing which company to invest in? Usually, one analyzes critical financial ratios, such as Return on Capital Employed (ROCE), Return on Invested Capital (ROIC), Return on Equity (ROE), and Return on Assets (ROA). These four essential ratios are extremely helpful when it comes to a well-defined evaluation of a company’s worth. Every successful investment decision ever made was based on the deep analysis of these indicators.

Today we will take a look at ROCE — a vital metric used to compare a company’s income with reference to the average capital employed in its business processes and assets.

The article covers the following subjects:

What Is ROCE and Why Calculate It?

Return on capital employed (ROCE) is one of the most important profitability ratios. It helps assess business viability, profit margins, and capital efficiency. To put it simply, this metric determines whether an entity can generate profit from the capital. Therefore, its primary goal is to establish the return percentage relative to the money invested in the respective endeavor.

The insightful nature of the ROCE ratio makes it one of the most popular profitability ratios used by many investors, stakeholders, and financial analysts. Comparing ROCEs of several companies enables the interested parties to choose the best option for investment.

Understanding the Essence of ROCE 

ROCE is highly valued for its role in evaluating entities from capital-intensive industries, for example, oil production or transportation. Technically, the ROCE calculation discloses the approximate amount of profit generated by the company per dollar employed in the business. There are other profitability ratios, such as, for instance, return on equity (ROE). However, ROE is only used to evaluate a company’s profitability in terms of its shareholders’ equity. Unlike this index, ROCE considers the combination of debt and equity. Imagine how useful it can be when you aim to predict the price of a company’s stocks over the next two years. The higher the percentage of profit per $1, the better. Thus, the ROCE ratio indicates which companies have more robust profitability.

Business owners understand the importance of the ROCE indicator. Here is the trend: investors show a preference for the companies, which showed impressive ROCE ratio growth over the years. Guided by the principle “stable ROCE is okay, but rising ROCE is perfect,” they have a good point. Companies with highly volatile or low ROCE demonstrate a lack of financial expertise, and buying their stocks or securities shouldn’t be considered a smart investment.

Though ROCE can serve as an effective tool for evaluating a business’ profitability, there are also several other financial ratios exploited to analyze a company’s performance. They include ROIC (return on capital invested), ROE (return on equity), and ROA (return on assets).

ROCE: Key Points

  • ROCE is a profitability ratio calculated to estimate a business’s performance in terms of its total capital management.

  • ROCE has lots in common with ROIC, another profitability ratio used to determine the return on invested capital.

  • To see the big picture, a company’s performance is often evaluated by calculating several key return ratios, such as ROCE, ROE, ROA, and ROIC.

ROCE, ROA, ROIC, and ROE: Comparison Table

Basis

ROCE

ROA

ROIC

ROE

Full Form

Return on Capital Employed

Return on Assets

Return on Invested Capital

Return on Equity

Calculation

Net operating income / Employed capital

Net operating income / Owned assets 

Net operating income / Invested capital

Net operating income / Average shareholders’ equity

Signature Features

This ratio is often used to compare the performance of different companies from the same sector, usually a capital-intensive one.

While ROA, just like the other ratios on the list, is used to evaluate a company’s profitability, it mainly helps analyze how efficiently the assets from the company’s balance sheet are used.

ROIC helps analyze a company’s performance by showing how successful an entity is at investing its capital. The ratio provides a more detailed view of the business’s profitability.

ROE ratios range significantly and greatly depend on the industry. There is still a shortcut for analysts, who usually consider ROE poor if it’s less than 10%. A ROE of 14% is generally recognized as acceptable.

ROIC (Return on invested capital) is another ratio that helps evaluate an enterprise’s economic efficiency in allocating its capital to favorable investments. The index sheds light on how successfully an entity uses its funds to generate profits by calculated return per each dollar invested.

ROIC and ROCE have a lot in common, as they are based on the same concept. However, their key components slightly differ. ROIC is calculated by dividing net operating profit by invested capital: 

Net operating profit after interest and tax / invested capital

The main difference starts with the component “Net operating profit after interest and tax,” as this metric reflects the actual earnings of the company but also considers the entity’s tax obligations, while ROCE doesn’t. 

How to Calculate ROCE (Return on Capital Employed)?

As we have already explained above, ROCE is an index used to analyze a company’s efficiency in terms of capital management. It can also help compare the profitability of several companies from the same industry. The key components needed for ROCE calculation are EBIT and capital employed. 

The formula used to calculate ROCE is as follows:

EBIT / Capital employed

For convenience, we can refer to the metric EBIT as “Net income before interest and tax.” EBIT (earnings before interest and tax or net income) is a financial metric that displays the profit a company gets as a result of its business activity. It’s a profit of an entity before deducting interest or taxes. Calculating EBIT is possible with the following formula:

Net revenue – Cost of sold products – Operating expenses

Capital employed, sometimes referred to as funds employed, is the overall capital of a company put to use to generate profit. The value is calculated as follows:

Total assets – Current liabilities

Click here to get your free template for ROCE calculation.

Going into Details: ROCE Example

Let’s consider two businesses from the same industry, for instance, transportation. Below you will find a ROCE calculation for hypothetical companies: Mark & Co and Rocket Corp.

Basis

Mark & Co

Rocket Corp.

Comments

Revenue

$24,695

$67,352

 

Total Assets

$21,793

$153,789

 

Current Liabilities

$5,449

$34,257

 

EBIT

$5,958

$12,992

 

Capital Employed

$16,344

$119,532

Total Assets minus Current Liabilities

ROCE (Return on Capital Employed)

0.36

0.10

EBIT divided by Capital Employed

At first glance, Rocket Corp. looks like a much more successful business than Mark & Co: it has solid revenue, more impressive EBIT and financial statements, and many assets under its control. The ROCE metric shows us a different side. The conducted analysis disclosed that Mark & Co uses its capital wisely and generates more profit in percentage terms.

Key Takeaways

Financial soundness is hard to evaluate if you don’t see the big picture and analyze the most important indicators of profitability of an entity, such as income statements, in isolation. That’s why investors calculate ROIC and ROCE profitability ratios to relatively estimate a company’s potential.

The outcome of calculating the operating profit helps interested parties decide whether a company is worth investing in or not. If the business’s ROCE has been demonstrating robust growth, that’s a good sign, indicating the management of the enterprises is going in the right direction and wisely investing the funds.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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