An investor’s biggest concern is whether a company will yield profits or not. To find out if a company is worth taking a risk for, we take the help of various profit-measuring metrics.
These financial ratios calculate the overall financial health of a company. So, you can make informed investing decisions. In the following article, we will discuss Return on Capital Employed (ROCE) indicator and why you shouldn’t ignore it while investing.
What is Return On Capital Employed?
Before giving you the generic definition of ROCE & its importance, try to answer a fundamental investing question- e
How do you measure the profit-making capacity of a company?
Checking how much revenue a company makes is a good start? Definitely! But that doesn’t tell us whether a company is profitable since there are always deductions. A company might be sustaining because of huge debts, for instance.
Moreover, it removes investors totally out of the picture! So what exactly does this tell you?
As an investor, you would like to know how much profits it can make based on its capital. If it can make more money per rupee (of its capital), the more profits its investors will get.
ROCE is a financial ratio that tells how efficiently a company utilizes its capital to yield profits.
To find out the ROCE of a company, divide a company’s operating profits, which are also known as EBIT, by its capital employed.
Formula of ROCE: (EBIT/ Total Capital) *100
Here, EBIT = total earnings before tax and interests.
Total capital = Equity capital + debt capital
You can also obtain total capital by subtracting total liabilities from total assets.
There are many benefits of ROCE. Two major benefits of ROCE are:
– It helps assess a company’s profitability and growth over time
– ROCE helps in comparing two companies and which is better for investing
Now, let’s discuss two of these in detail.
Assessing the Company’s Profitability and Growth
One of the primary benefits of using ROCE is that it helps assess a company’s profitability and growth. While investing, investors, fund managers, and stakeholders use this indicator.
A high ROCE ratio is preferable, which indicates that a company is efficiently using its capital to generate profit. Conversely, a low ROCE signifies a company is over-leveraged or that its operations are not as efficient as they could be.
Let’s take a simple example to understand this concept-
Assume that Company ABC has the following financial information for the year ended 31 December 2021:
Total assets = Rs 5,000,000
Non-operating assets = Rs. 100,000
Current liabilities = Rs. 200,000
EBIT = Rs. 300,000
Tax rate = 20%
ROCE is calculated as follows: Net Operating Profit After Tax (NOPAT) / Capital Employed
Where,
NOPAT = EBIT * (1 – Tax Rate)
Employed Capital = Total Assets – Non-Operating Assets – Current Liabilities
Using the above information, we can calculate Company ABC’s ROCE as follows:
NOPAT = EBIT * (1 – Tax Rate)
= Rs 300,000 * (1 – 0.2)
= Rs 2,40,0000
Capital Employed = Total Assets – Non-Operating Assets – Current Liabilities
= Rs. 5,000,000 – Rs. 100,000 – Rs. 200,000
= Rs. 4,700,000
Return on Capital Employed = (Rs 2,40,000 / Rs 4700000)* 100 = 5.1%
Therefore, Company ABC has a ROCE of 5.1%. The low percentage suggests that the company is over-leveraged and is not running its operation as it should, implying it could be a poor choice for investment.
Comparative analysis of companies with different capital structures
Another reason why ROCE is significant is that it lets you evaluate the profitability of two businesses. If both have the same ROCE, they make the same profit for each rupee of capital employed.
However, if one has a higher ROCE than the other, it is more profitable and generates greater profits for each rupee of capital employed. You can compare the ROCE of the companies to check which would be a better investment. Let’s see an example to understand this concept.
Suppose there are two companies: X and Z. Recently, both the firms made equal profits. Which company would you choose, X or Z?
Since we are short of information here, it is hard to tell.
Now, let’s say company X makes a profit of Rs. 200 on sales of Rs. 1,000, while Company Z makes Rs. 250 on Rs. 1,000 of sales. If we compare the two in terms of profitability, X has a 20% profit margin, while company Z has a 25% margin.
However, if we say X utilizes Rs. 500 of capital and B Rs. 1,000. And we found out X has a ROCE of 40% (200/500), whereas Z has a ROCE of 25% (250/1,000).
Based on ROE, which would you choose?
X is a better investment because it will shell out more money. And which, if invested back into the company, will benefit the shareholders more.
Limitations of Capital Employment Indicator
There is no doubt that ROCE is one of the financial ratios to consider when investing. But it is not a perfect metric. No single metric guarantees that/this company is worth taking the risk. Though, ROCE can give you an idea, which you can verify with other metrics such as Return on Equity (ROE).
Some of the limitations of ROCE are-
- It varies as per the accounting policies.
- ROCE does provide correct information on the performance of companies with large cash reserves.
The Key Takeaways
ROCE is all about the profit-making capacity of a company on its capital. In simple terms, it tells investors how much profit a business makes for every rupee invested. Calculating ROCE is easy. You divide its total earnings before tax and interests by the sum of total equity and total debt.
The financial ratio has many benefits. From assessing the growth and profitability of a business to comparing two companies with different capital, ROCE is one of the most reliable performance indicators for investors. It also tells how much a company is gaining from its investors.
Regardless of its benefits, ROCE is not a standalone metric for investment. It has some limitations. For instance, it may not provide correct information on the performance of companies with large cash reserves. Thus, you should refer to other metrics as well.
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