Overview
Return on Capital Employed is one of the profitability ratios used to assess the profits before interest and tax that the company could generate from its business by using shareholders’ Capital employed.
Capital employed is the fund that shareholders injected into the company plus other Capital and long-term debt. In other words, the fund that the company could use to generate profits.
Capital employed at the end of a specific period could be calculated by eliminating total liabilities from total assets at that period in the balance sheet. Return on Capital Employed is different from Return on Equity for two reasons.
First, it uses earnings before interest and tax, while return on equity takes net income into account. Second, this ratio use capital employed while returning on equity, taking into account only equity fund.
Capital employed is different from equity. Equity or shareholder equity is the accumulation of Capital employed, retained earning, and other equity items.
Return on Capital employed does not measure the net profit the company generates over the Capital employed. But it considers earning before interest and tax over the Capital employed.
This ratio ignores the interest expenses and tax expenses that the company pays during the years. Tax and interest are sound uncontrollable by management.
The Formula of Return on Capital Employed:
Return on Capital Employed is calculated by Earning Before Interest and Tax / Capital Employed
The essential parts to calculate this ratio are Profit Before Interest and Tax and Capital Employed. The compute is different from Return on Equity.
This ratio changes from time to time because of these two essential items’ changing. If EBIT is increased, ROCE is increased, and if Capital Employed increases, ROCE decreases.
You can find earnings before interest and tax in the entity’s income statement that assesses that ratio. We sometimes call this profit operating profits because they deduct the costs of goods sold and operating expenses.
And Capital employed is the balance sheet item, and you can calculate by using the above formula. This is the company’s fund to generate the above profits equity and long-term liabilities.
ROCE measures the return to all of Capital (Total Assets less Current Liabilities) while ROE measure only returns on Shareholders’ Equity. That is the reason why we pick up different profits to assess.
The following is a simple example to calculate Return on Capital Employed. In practice, you might find a more complex calculation than this.
Advantage of ROCE:
The calculation of Return on Capital employed is quite simple, and that is why it is mainly used to assess the performance of an entity or investment project.
It is easy to interpret, and most non-accounting managers could easily understand. Another advance of return on Capital employed is that this ratio could assess the entity or investment project in different sizes and different tax and interest perspectives.
As you can see, this ratio is measured in percentage. Hence, it is easy and sensible to see and assess the performance of different entities or projects of various sizes.
Not like residual income or another absolute financial measurement. The different entities might face different tax and interest expenses.
This ratio is also suitable for assessing the entity or investment project with different tax and interest perspectives as it uses only Earning Before Interest and tax.
For example, the group companies may have different projects with different sizes of invested Capital and different tax rates.
This ratio allows the group company to assess the performance by using this ratio since the tax charged and interest expenses are excluded from the calculation.
The disadvantage of ROCE:
The main disadvantage of ROCE is that this ratio uses information from historical financial data and could be manipulated by an intelligent CEO.
As we all know, this ratio is used to assess the performance of the company or project and, more important, to evaluate the performance of the management team.
While using this ratio to assess the performance, management could manipulate this ratio by using accounting techniques or not investing in new assets.
Why is management not willing to invest in the new assets if ROCE is used as performance measurement?
Well, investing in new assets leads to an increase in assets value and depreciation. This will subsequently decrease profit before interest and tax as well as ROCE.
Example:
ABC’s Statement of Profit and Lost show the amount Profit Before Interest and Tax amount USD 500,000 for the period ended 31 December 2015. Its statement of profit and loss shows Capital Employed amount of USD 1,000,000.
Calculate ROCE of ABC
Based on the formula above,
ROCE is 500,000/1,000,000 = 0.5 or 50%
As we can see, the ROCE of ABC is 50%, and it sounds pretty well for ABC. But, measuring this ratio alone and concluding the performance ABC by saying that it is well-performing might not be 100% correct.
Remember, this ratio is significantly affected by accounting policies. Maybe, ABC fixed assets are not quite old, and depreciation expenses are pretty low.
There are many other reasons to make this ratio so good like this.
Written by Sinra
