10 December 2024
What to know about Return on Capital Employed (ROCE)
6 minutes
Running a successful business isn’t just about the sales you make, the service you provide, or even your net profits at the end of the financial year. Business owners also reinvest their money year on year as their company develops, and when you do that, you need a way to make sure that those investments are generating a solid return. The standard way of measuring this is by calculating your return on capital employed (ROCE).
In this post, we give you the business owner’s guide to ROCE, answering key questions like:
- What is return on capital employed?
- What’s the formula for ROCE?
- Is ROCE a good measure of a business’ financial stability and growth?
With a solid understanding of ROCE (and some of the other metrics you can use to measure success), you’ll be in a better position to assess the overall health of your business and make decisions about where to invest.
What is return on capital employed?
Put simply, ROCE is a measure of the profits (returns) you’ve made from the money (capital) you’ve reinvested (employed) in your business.
If your business is profitable and you have money left over after you’ve paid yourself, your employees, your rent, utilities, loan repayments, etc., you’ll reinvest the money in the business to help you stay competitive and expand in the coming year.
For example, this money (the “capital employed”) could go towards:
- Training or employing new staff members
- Expanding or updating the equipment and infrastructure you need to run your business
- A new venue or premises with room for growth
- Buying more stock to help you fulfil more orders
But what does the return on capital employed show you as a business owner?
Because these investments can represent big financial decisions – and because they can be so important for the growth and success of your business – you’ll want to be sure that they’ve paid off. So, at the end of a certain period (like the financial year), you use an ROCE formula to measure the amount of profit you’ve made as a direct result of the money you’ve put back into your business.
Your business’ ROCE is a great number to include in your accounting because it turns these complex, sometimes intangible, results into a simple percentage.
The number is easy to grasp and you can quickly compare it to your previous performance or your forecast. It’s also a useful tool if you want to see how your company is performing relative to other businesses in your area or industry.
Most importantly, when you have this solid evidence to analyse, you can see how profitable your investments have been and how efficient they were in terms of the expense vs the return. Ultimately, this helps you to make more informed decisions about which areas of your business to invest in in the coming year.
How to work out return on capital employed
To figure out your ROCE, you need a couple of other numbers to hand before you begin.
- Your total capital employed for the period you want to measure. You get to this number by subtracting your liabilities (the money you owe, like income tax and accounts payable) from the value of your assets (like your cash and property).
- Your earnings before interest and tax (known as EBIT). You get this number by subtracting your costs (the cost of goods and services and your operating expenses) from your annual revenue.
Then, to get your ROCE, you divide your EBIT by your capital employed.
The typical return on capital employed formula looks like this:
EBIT / capital employed = ROCE
For example, imagine you run a retail store (which is an industry with quite a low ROCE on average because of the high capital costs of running the business).
The first part of the equation is value of assets – liabilities = capital employed. If you have liabilities of £35,000 and assets of £160,000, your total capital employed is £125,000.
The second part is annual revenue – COGS and operating expenses = EBIT. If you have an annual revenue of £130,000 and total costs of £110,000, your EBIT is £20,000.
The EBIT (£20,000) divided by the capital employed (£125,000) leaves you with an ROCE of 0.16, or 16%.
Is a high ROCE good or bad?
Generally speaking, the higher the ROCE, the better. It shows that you’re getting good returns from the money you’re investing in your business, which is a sign of a healthy business model and a strong customer base.
This being said, it’s important to know that ROCE isn’t the only measure of a stable business, and there are some limitations to the information it can give you.
While a high ROCE is a good thing, bear the following things in mind.
1. ROCE can’t be used to compare businesses in different industries
Because so many different factors affect your business’ expenses and profits, ROCE averages only apply within individual sectors.
For example, you could compare the ROCE of the retail store we discussed above (16%) to the ROCE of the tech company with an office in the same town (which could be closer to 30%), but this doesn’t actually tell you about how financially successful each business is. They’re operating with very different costs, and economic factors like the cost of living affect them in different ways.
On the other hand, if you were an investor looking for a new venture in tech, it would be fair to say that a business with an ROCE of 30% seems to offer a higher chance of better returns than one with an ROCE of 20%.
2. ROCE only measures past performance
Because ROCE measures how your past investments are performing, it’s useful for informing your business decisions but not for forecasting your profits in the next financial year. This is particularly true if the investments you’re making involve big changes at your company – for example, opening a new location or expanding your product line – as the results of these changes can be difficult to predict.
3. ROCE ignores other measures of success
While people like lenders, business insurers, and investors may be interested in your company’s ROCE, it’s only one of many factors that can influence their decisions.
While a higher than industry-average ROCE is a good sign, you’ll also have to look at other metrics like cash flow, revenue growth, and the depreciation of the value of your assets to get a true picture of how your business is performing financially.
Plus, if you’re interested in your ROCE because you want to grow your business, you should also take other KPIs like customer satisfaction, employee turnover, and brand awareness into account as you plan your strategy for the coming year.
What’s the difference between ROCE and ROE?
ROCE is one way of measuring business profitability, but as you research this topic, you might encounter other similar acronyms that also describe your performance.
- ROE stands for return on equity. Whereas ROCE measures how well a business owner has reinvested their profits, ROE shows how the company is managing the money invested by shareholders. The formula for ROE is net income / average total equity = ROE. It’s a number that investors and shareholders will want to know, but it doesn’t give a comprehensive view of how profitable or efficient your company is overall.
- ROIC stands for return on invested capital. The formula for ROIC is operating profit after tax / value of invested capital = ROIC. It’s a very similar calculation to ROCE, but it involves subtracting taxes from the EBIT to use the net profit in the calculation.
ROCE: the bottom line
ROCE measures the profitability and efficiency of your investment in your company as the business owner. This is important to investors, analysts, and managers who might be interested in a more detailed picture of how your business is running and what your true profits are. As a business owner, you can also use it to look back and evaluate the decisions you took for your business the previous year so you can decide if you want to explore different avenues for growth in the future.
While a higher ROCE is always preferable to a lower one, it’s not the only number you need to know. It’s also important to keep an eye on:
- Your cashflow and revenue growth
- The average ROCE for your industry
- Your ROE and ROIC figures
- The other KPIs that show whether you’re meeting your business goals
When your goal is to grow your business, you need insurance coverage to match. Talk to the experts at Howden today for specialist cover for all types of small businesses.
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