Calculate and Interpret Return on Capital Employed (ROCE)
The return on capital employed (ROCE) is a ratio expressed as a percentage that is used to measure the return a company generates from the capital it employs. The return on capital employed is often used to compare the performance of two or more companies to assess how efficiently resources are being used. A low ROCE indicates inefficiencies, even if the company demonstrates a high profit margin. Analysts often use ROCE to determine whether a company can afford its cost of capital.
How to Calculate Return on Capital Employed
The formula for return on capital employed can be written as:
ROCE = Net Income / Capital Employed
Where capital employed = Average debt liabilities + Average shareholders’ equity
In comparing a company’s net income to the combined sum of its debt and equity, an investor can get a sense of how utilizing leverage impacts the profitability of a company.
The ROCE shows the value the business generates through its assets and liabilities. For example, a capital-intensive business that shows minimal profits will have a smaller return on capital employed than a company that employs less capital but shows the same level of profit. In this way, the ROCE can help an investor understand how much a company gains from its assets or loses for it liabilities.
Using and Interpreting the Return on Capital Employed
The ROCE is an important tool to help investors find those companies that demonstrate good value and potential for growth. The measure can help determine which businesses are earning more in relation to the price paid by investors (a GARP approach to stock investing).
Critics of ROCE, however, argue that because it measures book value, the ROCE increases as assets are depreciated, even when cash flows are held consistent. This can favor older businesses with depreciating assets.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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