Return on capital employed (ROCE)

Return on capital employed (ROCE) measures operating earnings relative to the long-term capital committed to a business. It helps answer whether management is producing an adequate operating return from the funds supplied by owners and long-term creditors.

When to use it

• Answer the key performance question: “How well are we generating earnings from our capital investments?”

• Include the KPI in the financial perspective.

• Compare capital productivity across periods, business units or genuinely similar companies.

• Test whether returns exceed the cost of the capital used to produce them.

Origins

ROCE developed from the broader tradition of return-on-investment and financial-ratio analysis. Early industrial management systems, including the DuPont return framework, decomposed profit relative to invested capital into margin and asset use. ROCE became a common British and international accounting term, but no single definition or inventor governs current practice.

What it is

Perspective: Financial perspective.

Key performance question: How well are we generating earnings from our capital investments?

ROCE normally compares earnings before interest and tax (EBIT) with capital employed. EBIT is the numerator, not the denominator: it represents operating earnings before the financing cost owed to providers of debt and equity.

Capital employed can be defined as total assets less current liabilities, or equivalently as equity plus long-term interest-bearing finance when classifications reconcile. The definition should match the operating scope of the numerator. Return on average capital employed (ROACE) uses an average balance, which is usually preferable when capital changes materially during the period.

A higher ROCE can indicate stronger margin, more efficient capital use or both. It can also result from old depreciated assets, disposals, underinvestment or accounting changes. The ratio should be decomposed and considered with cash flow, growth, asset condition and risk.

How to use it

Measurement

Define operating profit, capital employed, tax convention and period consistently. Remove or disclose exceptional items, non-operating assets and major acquisitions when they would distort comparison. Use average capital for a flow earned throughout the period.

Data collection method

Derive EBIT from the income statement and capital employed from the balance sheet and notes. Reconcile leases, goodwill, provisions, pensions, discontinued operations and intercompany balances when comparing entities or units.

Formula

ROCE is commonly calculated by dividing earnings before interest and tax by capital employed:

Frequency

Annual measurement is common, with rolling or interim analysis where capital allocation decisions require a more current view.

Source of the data

Use controlled accounting records, published financial statements and supporting notes. Management reporting may provide a more useful operating view if definitions reconcile to reported data.

Cost/effort in collecting the data

The basic inputs are readily available, so calculation cost is low. Creating a genuinely comparable operating-capital measure can require substantial adjustment and judgement.

Target setting/benchmarks

Compare with relevant peers and the organisation’s own history, but also with a properly matched cost of capital. A return above the hurdle may create value even when it falls below the current portfolio average. Avoid one target for businesses with different risk, maturity and capital intensity.

Example

ExxonMobil historically reported a return on average capital employed and sometimes referred to it as ROCE. Its corporate definition used net income excluding the after-tax cost of financing over average capital employed. The company applied the definition consistently to assess historical capital productivity in a capital-intensive, long-horizon industry, while using additional cash-flow measures for investment decisions.

Source: ExxonMobil quarterly report, filed 11 March 2009

Top practical tip

Decompose ROCE into operating margin and capital turnover, then reconcile changes in asset age, leases, acquisitions and working capital. This reveals whether improvement reflects better economics or merely a smaller recorded denominator.

Top pitfall

Do not reject every project below the company’s current ROCE. If the cost of capital is 10%, an appropriately risk-adjusted investment returning 20% may create value even when a business-unit target is 30%. Also guard against depreciation and inflation making older assets appear superior to newer capacity.

Further reading

www.accountingformanagement.com/return_on_capital_employed.htm

www.wikinvest.com/stock/Exxon_Mobil_(XOM)/Return_Average_Capital_Employed_Roce