## Return on Capital Employed

##### Published: Mar 2004

Any investor considering a project will look at the return that can be generated. When the investment is a shareholding in a company, the potential investor will want to assess the profitability of the company. There are a number of different ways of establishing this. One of the most commonly used is the Return on Capital Employed (ROCE).

• ROCE is a concept which is used by providers of capital (investors and banks) and companies to measure profitability.
• ROCE is defined as earned profits divided by total capital employed.
• Earned profits are usually defined as profit before interest and tax (PBIT).
• Total capital is usually defined as total assets minus current liabilities. This is the same as long-term debt plus shareholders’ equity.

This can be seen as ROCE = $$\frac{profit \: before \:Interest\: and\: tax}{total \: capital \:employed }$$

#### Illustration of ROCE

Consider a company which produced profits before interest and tax of €12,345,000 in 2002. It had €200m of shareholder capital and a number of short-term loan facilities.

In 2002, the company generated a ROCE of $$\frac{12,345}{200,000\:} = 6.17\:$$ %

In 2003, it raised an additional €200m through a long-term bond issues in order to both fund an expansion programme and to repay some of the short-term debt. This meant that the total capital employed increased to €400m. During this period, its profits grew to €23.5m.

These figures mean that, in 2003, the company generated a ROCE of $$\frac{23,456}{400,000 \:} = 5.86\:$$ %

This illustration highlights some of the dangers of ROCE. Although ROCE fell in 2003, the profits earned by the company almost doubled. The main reason for the decline in ROCE was the injection of capital into the business. Managers would argue that it takes longer than a year to translate that capital injection into profitability.

At the same time, the company was able to consolidate some of its short-term debt. This debt had not been considered in 2002 ROCE, but was in 2003.

Managers will want to ensure that the ROCE remains above the company’s borrowing rate. If not, any additional borrowing will reduce the company’s earnings.

ROCE is a useful benchmark figure for treasurers and other company managers as well as for investors. It is easy to calculate and provides a clear reference against the current cost of borrowing. However, the illustration above shows that the ROCE should not be used in isolation as a measure of profitability. Changes should be explained using alternative financial ratios and with narrative.