Return on Capital Employed Formula

Return on Capital Employed Formula

Return on capital employed Formula has been given below. Return on capital employed or ROCE Formula has been explained with an example below. Return on Capital employed is calculated by dividing PBIT (Profit before Interest and Tax) with capital employed.

ROCE         =   Profit before Interest & Tax    .                                   Capital Employed

Return on Capital Employed Example

Company’s Equity                     =   160,000

Company’s Long Term Debt      =      80,000

Profit of company                      =   60,000

What would be the return on capital employed?

Solution

In first place we would calculate the capital employed by the company, and then with the help of capital employed calculation (figure), ROCE would be calculated.

Capital Employed = Equity + Long Term Debt

= 160,000 + 80,000

= 240,000 (Capital Employed)

= 60,000/240,000

=25% (ROCE)

Significance of Return on Capital Employed Calculation

ROCE calculation shows the profit generated from the available resources. The Financial performance (profit earned or generated) is usually shown in terms of percentage %. Return on Capital Employed is an important toll to compare the performance of different companies in same industry.

Return on capital employed information can be used for investment appraisal. A project should be accepted, if ROCE from a project is greater than its cost of Capital. It means that expected Return from the project is greater than cost of financing the project.

Reason for Interest Exclusion

Interest is excluded, while calculating the return of capital employed, because different companies have different financial structures, thus interest expense can distort the real financial performance, therefore  interest is excluded from the profit (Profit before interest) to present more realistic picture of financial performance.

Ideal Return on Capital Employed

Return on capital employed varies from industry to industry. For high risk project or industries, the return on capital is expected to be high and for low risk industries the return on capital employed is expected to be low.

Limitations of Return on Capital Employed

First Limitations or disadvantage of capital employed is its profit based calculation. We know that Profit can easily be manipulated by accounting policies.  ROCE is a relative measurement of the financial performance. ROCE ignores or does not take into account the time value of money. ROCE does not take into account size of the investment. These Limitations can be listed as follow

1.    ROCE is based on profit , which can be easily manipulated by the management.

2.    ROCE calculation provides only relative measurement of financial performance.

3.    ROCE does not take into account the time value of money

Advantages of Return on Capital Employed

First advantage of return on capital employed is its simple calculation. ROCE is profit based calculation; therefore account manager people love this method for investment appraisal. Advantages of Capital employed can be listed as follow

1.    ROCE has very Simple formula

2.    ROCE is based on one of the well known and fundamental concept of accounting i.e. profit.

3.    ROCE may be used for investment appraisal

4.    ROCE is useful tool to compare financial performance of different companies