RETURN ON CAPITAL EMPLOYED (ROCE)

We learned about Average Return in our previous article and tried to make Mr. Bambani one step closure to understand what we meant by average return . But while taking the example we took ROCE of companies under FMCG sectors. 

Many of us might get curios about what ROCE meant? What we can understand by ROCE of different companies? How we can calculate ROCE? what all component do we consider while calculating ROCE? we will definitely make out all these queries by the end of this article.  

What is Return on Capital Employed(ROCE)?

For a non-finance person, company is doing good if it generates profits or generates more profits over the period of time, right? 

But what they are lacking here is consideration of how much profits they are generating by using the available recourses. Here resources means shareholder's funds, long term Debts and their retained earnings, in short, capital employed. we are going to understand this a bit later. 

Before that the first thing we need to understand is ROCE is a ratio showing relationship between earnings i.e., earnings before interest and tax with capital employed.

for simplification,

Components of Return on Capital Employed

Here, 

• ROCE may be used to analyze the capital efficiency and profitability of the company. 'Profitability' refers to financial performance of business and 'Capital Efficiency' refers to how successfully a company generates profits from its capital when it is used.
• Earning before Interest and Tax is the operating income without deducting interest  and tax cost. Operating income is basically the income company is generating from it's principal (main) business. Further it can also be calculated by deducting cost of goods sold(COGS) and operating expenses from the revenue of the business. 

           EBIT = Revenue - (COGS + Operating expenses)

• Capital Employed, many learners find difficulty to understand this term but I'll make you well versed with this with a very basic example.   

Capital employed is nothing but the funds company utilize in it's operations to generate profits. There are two approaches to ascertain the amount of capital employed. Let's understand both approaches one by one.

Capital Employed can be ascertained by Liabilities approach or by assets approach. But it should be noted that whichever approach is followed, the amount of capital employed will be same. Following figure can clear both approaches at one glance:

When Liabilities approach is followed- 

It is computed by adding :

• shareholder's Fund i.e., Share capitals, Reserves and surplus
• Non- Current liabilities i.e., Long term Borrowings and Long term Provisions. 

When Assets Approach is followed-

It is computed by adding :

• Fixed assets : Tangible and Intangible Fixed assets,
• Non- Current Trade Investments, and 
• Long Terms Loan and advances.
• Working capitals i.e., (Current Assets - Current Liabilities)

Now, let us take an example of AB Company,  Here is the balance sheet of AB Company to calculate capital employed for the Year ending 2021-22 : 

Here, first we calculate Capital employed from Liabilities approach- 

Capital Employed = Equity Share capital +Reserves +Non- Current Liabilities  

                          = $100000+$156500+$205000

                          = $461500

Secondly we calculate Capital Employed from Assets Approach-

Capital Employed = Non-Current assets + Working Capital

                          = $459500 + ($20000-$18000)

                          = $461500

Further, if we extend our example of AB Company and  for year 2021-22, Earning before Interest and Tax is $50000

Then, Return on Capital Employed would be -:  

ROCE = ($50000/$461500)*100 = 10.83%

WHAT WE ARE CONCLUDING FROM ROCE?

Here are some points we can conclude from this ratio-

• How efficiently company is able to generate returns from the capital invested.
• Higher ROCE is always more favorable as it indicates best utilization of Capital.
• Basically this ratio is showing how much operating income is generating for each dollar invested in the company as capital.

Here in our example, We can conclude that for $ 1 of capital employed company is generating $0.1083 from operating income.

We can compare this ratio with the ROCE of different companies to analyze the profitability of the companies in same sector. Higher ROCE is always a good indicator.

Thankyou for your patience!

I'll be right back with more basic terms used in finance and try to make it as simple as ROCE✌