What is Return on Capital Employed(ROCE)?

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ROCE = Return on Capital Employed.
It measures how efficiently a company generates operating profit from the capital invested in the business. It’s a profitability ratio used to compare returns between companies and to see whether the business is earning more than its cost of capital.

Formulae (two common forms)

  1. ROCE (using EBIT)

ROCE=EBITCapital Employed\text{ROCE} = \dfrac{\text{EBIT}}{\text{Capital Employed}}

where EBIT = Earnings Before Interest and Taxes (operating profit).

  1. ROCE (after tax, using NOPAT) — sometimes preferred because it reflects the operating profit available to both debt and equity holders:

ROCENOPAT=EBIT×(1−tax rate)Capital Employed\text{ROCE}_{\text{NOPAT}} = \dfrac{\text{EBIT} \times (1-\text{tax rate})}{\text{Capital Employed}}

where NOPAT = Net Operating Profit After Tax.

What is “Capital Employed”?

Two equivalent ways commonly used:

  • Total assets − Current liabilities, or

  • Equity + Interest-bearing debt (long-term debt + short-term borrowings).
    Both should give the same result if the balance sheet items are classified consistently.

Interpretation

  • ROCE shows the return generated per unit of capital used.

  • Higher ROCE = better (company uses capital more efficiently).

  • Compare ROCE to the company’s WACC (weighted average cost of capital):

    • If ROCE > WACC → company creates value.

    • If ROCE < WACC → company destroys value.

  • Compare across companies in the same industry (capital intensity differs a lot across sectors).

Worked numeric example (step-by-step arithmetic)

Assume a company has these numbers (in ₹ lakhs, for simplicity):

  • Sales (Revenue) = ₹1,000

  • Cost of goods sold (COGS) = ₹600

  • Operating expenses (excluding depreciation) = ₹150

  • Depreciation = ₹50

  • Interest expense = ₹20 (irrelevant for EBIT)

  • Tax rate = 30%

  • Total assets = ₹1,200

  • Current liabilities = ₹300

Step 1 — calculate EBIT (operating profit):
EBIT = Sales − COGS − Operating expenses − Depreciation

Compute digit-by-digit:

  • Sales − COGS = 1,000 − 600 = 400.

  • 400 − Operating expenses = 400 − 150 = 250.

  • 250 − Depreciation = 250 − 50 = 200.
    So EBIT = ₹200.

Step 2 — calculate Capital Employed:
Capital Employed = Total assets − Current liabilities = 1,200 − 300 = 900.
(Or Equity + Debt would also equal ₹900 in a balanced sheet representation.)

Step 3 — compute ROCE (EBIT / Capital Employed):
ROCE = 200 ÷ 900.

Digit-by-digit: divide numerator and denominator by 100 → 2 ÷ 9 = 0.222222...
As a percentage: 22.22% (rounded to two decimals).

So ROCE = 22.22%.

If you prefer after-tax (NOPAT) version:
NOPAT = EBIT × (1 − tax rate) = 200 × (1 − 0.30) = 200 × 0.70 = 140.
ROCE (NOPAT) = 140 ÷ 900 = 0.1555... → 15.56%.

Which to use depends on your analysis: EBIT-based ROCE is common for cross-company operating return comparisons; NOPAT-based is useful when comparing to WACC (which is after-tax for debt).

Practical notes, caveats & pitfalls

  • Industry differences: Capital-intensive industries (utilities, telecom, airlines) typically have lower ROCE than software or services. Always compare within industries.

  • Working capital swings: Large seasonal working capital needs can distort Capital Employed; better to use a multi-year average of capital employed for trend analysis.

  • One-off items: Non-operating gains/losses or extraordinary items can distort EBIT — use adjusted operating profit for cleaner comparisons.

  • Lease accounting & goodwill: Accounting changes (e.g., capitalization of leases, acquisitions creating goodwill) affect capital employed — adjust if comparing pre/post accounting-change periods.

  • Capital structure neutrality: ROCE uses operating profit (pre-interest) so it’s largely independent of financing mix; that’s why it’s often preferred over ROE when comparing companies with different debt levels.

  • Compare to cost of capital: A single ROCE number is less meaningful unless you know the company’s cost of capital (WACC). ROCE > WACC = value creation.

How to compute quickly from financial statements (checklist)

  1. From the income statement get EBIT / Operating profit (remove one-offs).

  2. From the balance sheet compute Capital Employed = Total assets − Current liabilities (or Equity + Debt). Consider averaging opening and closing capital employed for the period.

  3. Use the formula and, if needed, compute NOPAT (EBIT × (1 − tax rate)).

  4. Compare with prior years, peers, and WACC.

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