Return on Capital Employed ROCE Formula & Interpretation

 Return on Capital Employed ROCE Formula & Interpretation

Return on Capital Employed, ROCE is the financial ratio to analyze company performance. ROCE indicates the efficiency of utilization of total capital employed by a company to generate profit.

Return on equity ROE deals with the returns on the investment of the shareholders and

Return on Capital Employed, ROCE considers not only equity capital but it also includes the liabilities like a loan or any debt which are used as a capital in the business.   

 

 

               

 Equity can be raised in three ways

Equity Share Capital: Initial Investment by promoters.

Reserves & Surplus: Cash + Profit ( This maybe after a few years as the company grow their business they will earn some profit and all profit will not be used or distributed to shareholders but they keep theses money as a reserve.)

Preferred Shares or Equity. This can be raised from friends and families or strategic partners by creating confidence and promise that they will get some percentage of money on their investment than the other common equity shareholders

Equity Capital, Reserve & Surplus are considered as Common Equity.

Total equity includes common + preferred equity

Liabilities are also two types of liabilities

Current Liabilities: Its payment condition is within 1 year. It includes short term dues, Trade Payables, Advances & Overdue, and other short term dues.

Noncurrent Liabilities: Its payment condition is after 1 year. It includes long term debt (loan), Differed tax liabilities and other long term liabilities.

Let us understand by Example:

EBIT (Earnings before Interest and Tax)(Operating profit)	100,00,000 (100L)
Interest on Debt (-)	30,00,000 (30L)
PBT Profit before Tax	70,00,000 (70L)
Tax @ 30% (-)	21,00,000 (21L)
PAT (Profit after tax) (Net profit)	49,00,000 (49L)

 The ROCE = Profit (EBIT)/ Capital Employed.

The priority of payment for any company is

1.       Debt

2.      Tax

3.      Preferred equity

4.      Common equity

In ROE, we have to calculate on returns on equity we have to consider PAT for the calculation as the priority of payment is 1. Debt interest 2. Tax. As in total equity, we are not considering the debt amount.

But in ROCE,

Profit: Here we have to consider the profit as PBIT since we are calculating ROCE on total capital (Equity + Debt) hence as per payment priority only interest will be deducted from the returns.

Capital Employed: There are different ways that are being used by different analyst.

Some analysts and investors may choose to calculate ROCE based on the average capital employed, which takes the average of opening and closing capital employed for the time period under analysis.

 If you observe ROCE on three different websites for the same company. They all have used different formulas to calculate ROCE. But one should follow the same formula to get consistent results for different companies.

1.      ROCE = EBIT/(Equity + Noncurrent liabilities (long term debt))

 Here noncurrent liabilities are considered because they think that there is no high impact of short term liabilities as these are to be pay within one year only.

 2.      ROCE = EBIT/ (Equity + Long term debt).

 Here they are considering only long term debt they are not considering the short term debt. They are thinking that whatever money they are utilizing as capital is to be only considered. Since the short term is to be paid within a year there is no impact hence only long term debt is considered.

 3.      ROCE = EBIT/(Equity + Long term debt + Short term debt)

 This is ideally the correct definition.

 Let us understand by example:

Suppose company A has established with a capital of 4 crores. With the following details.

Initial Investment	200L
Reserve & surplus	50L
Preference shares equity @ 15% (promise by the company as a dividend)	50L
Short Term Debt @ 10% interest rate	50L
Long term Debt	100L

 Financial Statement

EBIT (Earnings before Interest and Tax)(Operating profit)	100,00,000 (100L)
Interest on Debt (-)	30,00,000 (30L)
PBT Profit before Tax	70,00,000 (70L)
Tax @ 30% (-)	21,00,000 (21L)
PAT (Profit after tax) (Net profit)	49,00,000 (49L)

 

ROCE = EBIT / Equity + Short term + Long term debt)

             = 100L/ (300L+50L +100L)

            = 22.22%

With another formula i.e. ROCE = EBIT/ (Equity + Long term Debt)

            = 100L/(300L +100L)

            = 25%.

Comparison between two companies from the same sector.

(Same sector company)	Company-A	Company-B
Initial Investment	200L	400 L
Reserve & surplus	50L	300L
Preference shares equity	50L	200L
Short Term Debt @ 10% interest rate	50L	500L
Long term Debt	100L	2500L
EBIT (Earnings before Interest and Tax)(Operating profit)	100L	800L

 

ROCE = EBIT / Equity + Short term + Long term debt)

ROCE company A   = 100L/ (300L +50L + 100L)

                                    = 100L/450L

                                    = 22.22%

ROCE company B = 800L/ (900L + 500L + 2500L)

                                    = 800/3900

                                    = 20.51%

As you can see, Company B is a much larger business than Company A, with higher revenue, EBIT, and total capital. However, when using the ROCE metric, you can see that Company A is more efficiently generating profit from its capital than Company B.

Return on Capital Employed

Important points.

1.       ROE Vs ROCE

·         ROE doesn’t give overall picture of the return on capital.

·         ROE can be manipulated –More debt to increase ROE.

·         ROCE gives overall picture of the return on the total capital employed in the business.

·         ROCE can be compared to return from other investments like FD, Mutual fund, or Bonds. This is to make a decision about whether this money investment is really fruitful.

·         Invest only when ROCE > Cost of capital

Here what is the cost of capital?

For example, suppose if you have taken a loan @ interest of 12% then your ROCE > 12% otherwise there is no point in business. As if ROCE is less than 12% then you will not get any profit. All money will go to the lender (Bank)

Or ROCE > WACC (Weighted average of capital cost)

ROCE to be used for measuring the capital intensive companies like utilities and telecoms  

·         For the investor to invest in stock has to keep in mind following points.

·         If the company has not any debt then he should observe ROE and if the company is having any debt then he should see the ROCE.