What is a Return on Capital Employed?

Osmand Vitez

The return on capital employed, also called ROCE, is a corporate finance formula that determines the efficiency and profitability of capital investments. Capital investments often represent the purchase or acquisition of major assets used in business operations. Buildings, production facilities, equipment or other fixed assets are usually purchased by companies through the use of bank financing. In order to determine how well the company has used its capital to make these investments, companies use this formula calculation to compare this percentage against the interest rate on the bank loans used to make the capital investments. The formula consists of three parts: earnings before income in taxes (EBIT), total assets and current liabilities.

Capital employed refers to the performance and profitability of capital investments.
Capital employed refers to the performance and profitability of capital investments.

The numerator in the formula is the company’s total EBIT for a specific accounting period. EBIT is calculated by taking sales revenues less operating expenses and adding back any non-operating income generated by the business. Operating expenses usually include the cost of goods sold, cost to sell goods, and general or administrative expenses used to generate revenues for the business. Depreciation and miscellaneous expenses are also included in the company’s operating expenses.

The return on capital employed denominator represents the total assets owned by a company minus current liabilities. Total assets include both the current and long-term assets listed on the company’s balance sheet. Current assets typically include cash, marketable securities, inventories and accounts receivable. Long-term assets usually include any property, plant and equipment owned by the company to produce consumer goods or services. Current liabilities represent any money owed by the company, payable in less than 12 months. These liabilities often include accounts payable, short-term debt, trade credit or short-term bonds payable.

Most companies desire a high percentage of return on capital employed when making capital investments. For example, if a company has $2.25 million U.S. Dollar (USD) in EBIT, total assets of $14.5 million USD and current liabilities of $7.8 million USD, the company will have a 33.5% ROCE. This formula would be prepared in the following manner: $2.25 million USD divided by ($14.5 million USD less $7.8 million USD).

A flaw in theformula is that it uses the historical book value of long-term assets in the corporate finance calculation. The historical cost representing the book value of long-term assets may change depending on the type of asset and whether or not it has been amortized or depreciated according to traditional accounting rules. Improper asset values may over- or under-inflate the return on capital employed formula.

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