Return on Capital Employed (ROCE)

Introduction

• ROCE is a key financial ratio used to assess a business's financial performance.
• Main return from business activities is profit (revenue - costs).
• Businesses invest in inventories, stocks, warehouses, production facilities, and distribution capabilities to earn profit.

Definition

• ROCE measures the relative return (profit) on the amount invested in the business.
• Often shortened to ROCE.

Importance of ROCE

• Measures relative profitability, indicating how effectively a business turns its capital into profit.
• Useful benchmark for target rate of return on individual projects.
• Helps benchmark financial performance against competitors and the industry.

Calculation

• ROCE is expressed as a percentage:

  ROCE = (Operating Profit / Capital Employed) x 100

  • Operating Profit: Found in Income Statement.
  • Capital Employed: Total Equity + Non-Current Liabilities (found in Balance Sheet).

Example Calculation

Company X

• Non-Current Liabilities: £500,000
• Total Equity: £1,250,000 (Share Capital: £1,000,000 + Reserves: £250,000)
• Operating Profit: £400,000
• ROCE: (400,000 / 1,750,000) x 100 = 22.8%

Company Y

• Non-Current Liabilities: £700,000
• Total Equity: £2,500,000 (Share Capital: £1,000,000 + Reserves: £1,500,000)
• Operating Profit: £600,000
• ROCE: (600,000 / 3,200,000) x 100 = 18.7%

Interpretation

• Though Company Y has a higher operating profit, it has more capital employed, resulting in a lower ROCE compared to Company X.

Evaluation

• Widely used by financial analysts and easy to calculate using published financial information.
• Varies between industries due to different profit and capital investment levels.
• Useful for tracking changes over time and comparing relative financial performance of competitors.