Return on capital employed

The formula

: (Expressed as a %)

It is similar to return on assets (ROA), but takes into account sources of financing.

Capital employed

In the denominator we have net assets or capital employed instead of total assets (which is the case of Return on Assets). Capital Employed has many definitions. In general it is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities (or fixed assets plus working capital requirement).

ROCE uses the reported (period end) capital numbers; if one instead uses the average of the opening and closing capital for the period, one obtains return on average capital employed (ROACE).

Application

ROCE is used to prove the value the business gains from its assets and liabilities. Companies create value whenever they are able to generate returns on capital above the weighted average cost of capital (WACC). A business which owns much land will have a smaller ROCE compared to a business which owns little land but makes the same profit.

It basically can be used to show how much a business is gaining for its assets, or how much it is losing for its liabilities.

Drawbacks

The main drawback of ROCE is that it measures return against the book value of assets in the business. As these are depreciated the ROCE will increase even though cash flow has remained the same. Thus, older businesses with depreciated assets will tend to have higher ROCE than newer, possibly better businesses. In addition, while cash flow is affected by inflation, the book value of assets is not. Consequently, revenues increase with inflation while capital employed generally does not (as the book value of assets is not affected by inflation).

References

References

1. Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, Chapter 3.
2. (2009). "Corporate Finance: Theory and Practice". Wiley.
3. Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 37.