Return On Capital Employed (ROCE) is a financial ratio. It determines a company’s profitability and the efficiency with which the capital is applied. A higher ROCE indicates a more cost-effective use of capital. It is also called as Return On Total Capital (ROTC).
We know that when a company starts it has 2 types of capital, equity and debt. And ROCE is an important factor because it does not only focus on equity shareholders and their capital but focuses on the company’s capacity to perform its business on both the capitals, equity as well as debt. ROCE does not only focus on the equity because if the company is not generating returns more than the cost of debt capital, then it is not useful.
Return On Capital Employed (ROCE) = (Earnings Before Interests and Taxes (EBIT) ÷ Total Capital Employed) × 100
where, EBIT = Operating Profit
Total Capital Employed = Equity Capital + Debt Capital
Using it With Return on Equity (ROE)
Many investors who use ROE to evaluate a company, also focus on ROCE along with it. The reason behind this is that there are some businesses like utilities business, infrastructure business or the telecom business, where capital requirements are very high, and here ROE and ROCE are very crucial.
Let’s consider a company which has equity capital of Rs. 500 crores and debt capital (raised at 10% p.a interest rate) of Rs. 500 crores. Thus, its total capital employed is Rs. 1,000 crores. And the company generates an EBIT of Rs. 200 crores.
So, the ROCE will be
ROCE = (EBIT ÷ Total Capital Employed) × 100
= (200 ÷ 1000) × 100
Here, we can see that the returns are more than the cost of debt capital. This means that the company is generating good values for their shareholders. On the contrary, let’s say that the EBIT of the company is Rs, 75 crores. Then, the ROCE will be 7.5% [(75 ÷ 1000) × 100]. Thus, this would mean that the company is not generating more that the cost of debt capital. So, the value generation for equity investors is not good at all.
If a company’s ROCE is less than its cost of debt capital, then that company will never benefit from good valuations in their equity shares trading. Therefore, the number given out by ROCE is of great importance. Successful investors like Warren Buffet or Peter Lynch too give a lot of attention to ROCE.