Return on capital employed (including long-term Borrowing)

Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed. In other words, return on capital employed shows investors how many dollars in profits each dollar of capital employed generates.

ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into consideration long-term financing. This is why ROCE is a more useful ratio than return on equity to evaluate the longevity of a company.

This ratio is based on two important calculations: operating profit and capital employed. Net operating profit is often called EBIT or earnings before interest and taxes. EBIT is often reported on the income statement because it shows the company profits generated from operations. EBIT can be calculated by adding interest and taxes back into net income if need be.

Capital employed is a fairly convoluted term because it can be used to refer to many different financial ratios. Most often capital employed refers to the total assets of a company less all current liabilities. This could also be looked at as stockholders’ equity less long-term liabilities. Both equal the same figure.

Formula

Return on capital employed formula is calculated by dividing net operating profit or EBIT by the employed capital.

Return on Capital Employed = Net Operating Profit / Employed Capital

If employed capital is not given in a problem or in the financial statement notes, you can calculate it by subtracting current liabilities from total assets. In this case the ROCE formula would look like this:

Return on Capital Employed = Net Operating Profit / Total Assets – Current Liabilities

Where:

• Fixed Assets, also known as capital assets, are assets that are purchased for long-term use and are vital to the operations of the company. Examples are property, plant, and equipment (PP&E).
• Working Capital is the capital available for daily operations and is calculated as current assets minus current liabilities.

It isn’t uncommon for investors to use averages instead of year-end figures for this ratio, but it isn’t necessary.

Analysis

The return on capital employed ratio shows how much profit each dollar of employed capital generates. Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated by each dollar of capital employed.

For instance, a return of .2 indicates that for every dollar invested in capital employed, the company made 20 cents of profits.