2.5. Return on capital employed (ROCE)

Return on capital employed (ROCE) is a measure of efficiency and profitability that a business achieves from the capital employed. This ratio is calculated by dividing income before taxes by capital employed. Capital employed equals the company's equity plus non-current liabilities.

This ratio is sometimes considered a better representation of how efficiently a company utilizes its resources because it includes long-term debt in the analysis. A similar ratio is return on equity, but return on equity only includes equity in the denominator while return on capital employed includes equity and non-current liabilities (i.e., long-term debt).

Equity and non-current liabilities can also be expressed as total assets less current liabilities or, in other words, all long-term funds used by a company.

As a rule, return on capital employed should always be higher than the rate at which the company can borrow funds otherwise any increase in borrowing will reduce shareholders' earnings.

Return on Capital Employed (ROCE) Formula

Return on capital employed is calculated by dividing income before taxes by capital employed:

Capital employed equals a company’s equity plus non-current liabilities (e.g., long-term debt).

A variation of this ratio, return on average capital employed (ROACE), involves using the average capital employed in the denominator to avoid including high capital employed levels that can occur on specific dates (e.g., when a company incurs a long-term loan towards the end of a year):

Where the average capital employed can be calculated as follows:

(*) CE stands for capital employed.

Return on Capital Employed (ROCE) Example

In our example of Friends Company, to determine its return on average capital employed (ROACE), we will use the income statement and balance sheets available at the end of this tutorial. The ROACE ratio at the end of fiscal year 20X9 can be calculated as follows:

Note: $21,950 and $21,570 represent total shareholder’s equity plus long-term notes payable for 20X8 and 20X9, respectively.

The ROACE of 19.4% means that Friends Company generated net income before taxes of 19.4% on its average capital employed.

Important Notes

• One of the limitations of return on capital employed is the fact that it does not account for the depreciation and amortization of the capital employed. Because capital employed is in the denominator, a company with depreciated assets (e.g., an older company) may find its ROCE increase without an actual increase in profit.

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