Return on Capital Employed is one of the profitability ratios that use 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 is using earning before interest and tax while return on equity taking account of net income. Second, this ratio use capital employed while returning on equity taking account only equity fund.
Capital employed is different from equity. equity or shareholder equity is the accumulation of capital employed, retain earning, and other equity items.
Return on capital employed not measure the net profit that the company generates over the capital employed. But it taking account 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 most important parts to calculate this ratio are Profit Before Interest and Tax, and Capital Employed. The calculate is different from Return on Equity.
This ratio is changing from time to time because of the changing of these two important items.
If EBIT is increased, ROCE is increased and if Capital Employed is increasing, ROCE is decreased.
You can find earnings before interest and tax in the income statement of the entity that being assess that ratio. We sometimes call this profit operating profits because it is the profits after deducting 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 fund that the company uses 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 profit to assess.
The following is a simple example to calculate Return on Capital Employed. In practice, you might find a more difficult calculation than this.
Advantage of ROCE:
The calculation of Return on capital employed is quite simple and that is the reason why it is mostly used to assess the performance of an entity or investment project.
It is easy to interpret and most of the non-accounting managers could easily understand.
Another advance of return on capital employed is that this ratio could be used to 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 so it is easy and sensible to see and assess the performance of different entities or projects that have different 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 to assess the entity or investment project that have different tax and interest perspective as it uses only Earning Before Interest and tax.
For example, the group companies may have different projects with different sizes of invested capital as well as the different tax rates.
This ratio allows the group company to assess the performance by using this ratio since the tax charged as well as interest expenses are excluded from the calculation.
The disadvantage of ROCE:
The main disadvantage of ROCE is that this ratio is using information from historical financial data and it could be manipulated by smart CEO.
As we all know, this ratio is used to assess the performance of the company or project and more importance to assess the performance of the management team.
While using this ratio to assess the performance, management could manipulate this ratio by using the accounting techniques or by not investing in new assets.
Why 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 as well as depreciation. This will subsequently decrease profit before interest and tax as well as ROCE.
ABC’s Statement of Profit and Lost show 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 quite well for ABC. But, measure this ratio alone and make a conclusion on the performance ABC by saying that it is well-performing might not 100% correct.
Remember, this ratio is significantly affected by accounting policies. Maybe, ABC fixed asset not quite old and depreciation expenses are quite low.
There are many other reasons to make this ratio so good like this.
Written by Sinra