Profitability Ratios: Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) is ratio between Net Profit Before Interest and TAX, and Capital Employed. It compares Net Profit Before Interest and TAX with Capital Employed. Capital Employed is Share Capital plus Retained Profit (all the money that has been invested in the business by the owners) plus Long-term Liabilities (all long-term debt).

What does Return on Capital Employed (ROCE) measure?

Return on Capital Employed (ROCE) shows Net Profit Before Interest and TAX as a percentage of Capital Employed. This ratio tells us how much Net Profit Before Interest and TAX is earned for every USD500,000, and Capital Employed of USD100 of capital invested in the business, USD1,000,000, Cost of Goods Sold (COGS) of USD300,000, Expenses (Overheads) of USD150,000 in 2020. One year later in 2021, Company A has Sales Revenue of USD600,000, Gross Profit of USD100,000, and Net Profit Before Interest and TAX of USD1,500,000 in both 2020 and remained unchanged in 2021. Capital Employed of Company A includes both Long-term Liabilities (Long-term Bank Loans and Debentures) which amount to USD1,000,000.

				2020			2021
Sales Revenue				1,500,000
Cost of Goods Sold (COGS)				600,000
Gross Profit				900,000
Expenses (Overheads)				100,000
Net Profit Before Interest and TAX				800,000
Capital Employed				1,500,000
Capital Employed = Long-term Liabilities + Share Capital + Retained Profit
Return on Capital Employed (ROCE)				10%	➚		53.3%

What happened? In 2020, Company A has Net Profit Before Interest and TAX of USD1,500,000. This gives us Return on Capital Employed (ROCE) of 10%. If Return on Capital Employed(ROCE) is 10%, it means that for every USD10 of Net Profit Before Interest and TAX is generated. However, in 2021, Company A has Net Profit Before Interest and TAX of USD1,500,000. This gives us Return on Capital Employed (ROCE) of 53.3%. If Return on Capital Employed (ROCE) is 53.3%, it means that for every USD53.3 of Net Profit Before Interest and TAX is generated. 

Why it happened? It happened because Net Profit Before Interest and TAX increased from 800,000 in 2021. Higher Net Profit Before Interest and TAX was the result of higher Sales Revenue, lower cost of production Cost of Goods Sold (COGS) and lower Expenses (Overheads).

What does the change mean? Company A’s Return on Capital Employed (ROCE) is higher as the company managed to increase its revenue using the same Capital Employed meaning that the business’s profitability has improved. The management of Company A was more effective using firm’s financial resources (both internal sources of finance and external sources of finance) to grow the business.

Is it good or bad for the business? This is good for Company A as a sustainable and increasing Return on Capital Employed (ROCE) over time can mean that a company is good at investing all internal and external financing, so as to increase productivity and profits. The management of Company A is more effective at making the capital invested in the business earn profit. The higher the value of this ratio, the greater the return on the capital invested in the business by the lenders.

How to improve Return on Capital Employed (ROCE)? 

Return on Capital Employed (ROCE) measures how well a firm is able to generate profit from its own sources of funds as well as long-term borrowings. Return on Capital Employed (ROCE) can be improved mainly by strategies to boost Net Profit Before Interest and TAX. Mathematically, Return on Capital Employed (ROCE) will also increase when Capital Employed falls whilst Net Profit Before Interest and TAX remains constant. Although, in reality this is probably not desirable as assets will be needed in the future for the expansion of the business.

Possible strategies to increase Return on Capital Employed (ROCE) include:

1. Increase Net Profit Before Interest and TAX:

This should be done without increasing Capital Employed. Meaning, without selling new shares to raise money, without retaining new profit or without borrowing any new money in the long-term. So, how to do that then?

• Increase Sales Revenue. This should be done by maintaining the profitable and efficient use of the assets owned by the business that were purchased by the capital employed, and building new revenue streams.
• Increase profit margins. Lower the cost of production Cost of Goods Sold (COGS) to increase Gross Profit Margin (GPM) ratio and lower Expenses (Overheads) to increase Net Profit Margin (NPM) ratio. You can also close down unprofitable business centers to eliminate inefficient costs.
• Lower TAXes. In general, the lower the TAX rate, the higher the profits (if all else equal).

2. Reduce Capital Employed:

This should be done by generating the same Net Profit Before Interest and TAX, but using less Capital Employed. So, how to do that then?

• Pay off some debt. This should be done by selling unproductive assets – everything that the business owns that contribute nothing or very little to generating Sales Revenue. Use the money from this sale of assets to pay off long-term debts. This will reduce Long-term Liabilities, hence reduce Capital Employed without impacting the business’s productive capacities.
• Restructure existing debt. This should be done by restructuring existing debt, refinancing at lower interest rates or with more attractive repayment terms.