To start a business, an entrepreneur needs capital. This can be obtained in two ways, either equity or debt. Now, we have learned how to calculate returns if the business is funded with owned funds i.e., equity. This can be done by calculating the Return on Equity (ROE).

However, if the business is funded through both equity and debt i.e., borrowed capital, we cannot use the same method for the calculation and analysis of the return. We need a tool that can help in analysing the returns for both owners as well as for lenders.

To address this necessity, there exists a profitability ratio that takes debt into account during its analysis. This ratio is known as Return on Capital Employed (ROCE). In today's blog, we will delve into a comprehensive exploration of the ROCE ratio.

The term Return on Capital Employed (ROCE) denotes a financial metric that serves as a tool for evaluating a company's profit-making ability and capital efficiency. In simpler terms, this ratio provides insight into how effectively a company is generating profits from the capital it has invested. ROCE offers a comprehensive assessment of a company's profitability by considering its total capital utilization. This total capital includes both equity and debt.

In contrast to other financial metrics like Return on Equity (ROE), which exclusively examines profitability in relation to a company's shareholders' equity, ROCE considers both debt and equity. This approach helps in normalizing the analysis of financial performance for companies burdened with substantial debt.

But how is ROCE calculated?

ROCE is calculated as follows:

ROCE = Earnings before Interest or Taxes (EBIT) / Capital Employed

Where EBIT is also known as Operating Profits. To arrive at EBIT, we need to add Finance Costs (Interest Expenses) and Taxes Expenses to the Net Profits for the period.

Capital employed closely resembles invested capital. Capital employed is determined by deducting current liabilities from total assets, resulting in the sum of shareholders' equity and long-term debts.

Let us understand this with a practical example of ABC Company Ltd.

ROCE calculation would be as follows:

ROCE = EBIT / Capital Employed

= (85,000 + 20,000 + 21,250) / (7,50,000 – 2,00,000) = 1,26,250 / 5,50,000

= 22.95%

The calculation and interpretation of ROCE provide us with information about how well the company is employing its capital. In the year, the company generated a 22.95% return on its 5.5 lakh Rupees worth of capital. We can compare this with the previous year's ratio or with other companies in the same industry. On such comparison, we understand if the company has improved its capital efficiency. A higher ROCE ratio indicates higher returns generated for a given capital. Hence, a higher ROCE is generally considered as a positive indicator. Generally, the ROCE should be more than the interest rate at which the company has borrowed funds

While grasping the meaning and computation of ROCE is valuable, it's equally crucial to acknowledge its limitations. ROCE relies on historical financial data, which might not effectively capture current market dynamics or growth potential. Because ROCE predominantly emphasizes profitability and capital efficiency, excluding other vital aspects of financial performance like revenue growth, profit margins, cash flow generation, and return on equity, over-reliance on ROCE can result in a narrow perspective and an incomplete evaluation of a company's present and future standing.

Furthermore, it disregards the impact of a company's capital structure because the composition of debt and equity financing, is not considered by ROCE. Another drawback of ROCE is its suitability for comparing the performance of two firms within the same industry, but it may lack precision when comparing organizations across different sectors.

In conclusion, though there are some limitations, ROCE is a very helpful tool in analysing a company’s capital efficiency and its ability to make profit from the given amount of capital. However, this ratio alone cannot cover all the grounds of Fundamental Analysis of a company. To understand more of such ratios and factors in the study of Fundamental Analysis, you can explore my Fundamental Analysis course on the same.

Until next time!!!