ROCE

ROCE is an abbreviation used for the term RETURN ON CAPITAL EMPLOYED. ROCE is represented in a form of ratio. ROCE is a very important tool of accounting.  The basic purpose of investment in a business is to acquire reasonable return on the capital investment. Hence the Return on capital employed is used to determine the rate of success in a business under the light of its objective. Return on capital employed build a relationship between profit and the capital employed. Return on capital employed is used to determine and measure the efficiency and effectiveness of a business. It shows the overall profitability of a business. ROCE is helpful in the indication of percentage return on the capital employed of the business. Capital employed and the profit is the main features of return on capital employed.

There are number of ways used to define the capital employed but there are two main definitions of capital employed which are termed as GROSS CAPITAL EMPLOYED and the NET CAPITAL EMPLOYED.  Gross capital employed is the total assets in a business both fixed and current and the net capital employed means total assets minus liabilities. It is also related to the total capitals including capital reserves, revenue reserves, debentures and long term loans.

The formula to calculate ROCE is very simple and is represented by the following equation

Return on Capital Employed= (Adjusted net profits*/Capital employed) ×100

*Net profit before interest and tax minus income from investments.

Other representations of the formula used to calculate ROCE can be given by the following equations

ROCE Ratio = EBIT/ (Adjusted Net Working Capital + Net Fixed Assets).

 ROCE= Operating Income divided by Assets Employed = [Sales divided by Assets Employed] times [Operating Income before taxes and interest divided by Sales]

In order to calculate ROCE the capital employed should be calculated first. There are two methods used to calculate the capital employed. In first method calculations are done by using assets side. This can be done by adding the fixed assets at their net values, either at original cost or the replacement cost after subtracting the deprecation, investments on the business, current assets that includes cash in hands, cash in bank, stocks etc. To calculate the capital employed current assets have to subtract from total assets. To calculate capital employed following formulas are used

Gross capital employed = Fixed assets + Investments + Current assets

Net capital employed = Fixed assets + Investments + Working capital

Working capital = current assets − current liabilities.

In second method capital employed is calculated by using the liabilities side of the balance sheet. The main elements present in this method are the share capitals that are the issued share capital (equity + preference). The second element is reserves and surpluses. It includes general reserve, capital reserve, profit and loss account, debentures and other long term loan.

The second main feature of ROCE is the profit. In order to calculate the profit for ROCE we have to use the concept of “capital employed used”. The profit used in the formula of ROCE must have to be earned on capital employed in a business. The net profit should be taken before the payment of taxes. This is because the taxes are not related to the earing capacity of the business; they are related to the profit of the business.

Now let us consider an example of ROCE ration. We will take two different companies. The first company is ACN a large consulting company. The second one is EMC and it is a data storage company. Both the companies are large where EMC is related to technology and ACN is related to consulting. The financial numbers given in the data are from February 28, 2007 for Accenture and December 31, 2006 for EMC.

Return On Capital Employed (ROCE) Ratio Calculation
    ACN EMC
Earnings Before Interest and Taxes (12 months) $2,487,150 $1,424,141
       
Current Assets    
  Cash $2,959,939 $1,828,106
  Short Term Investments $182,007 $1,521,925
  Net Receivables $3,968,561 $2,110,360
  Inventory   $834,800
  Other Current Assets $446,830 $225,396
  Total Current Assets $7,557,337 $6,520,587
Excess Cash & Short Term Investments $182,007 $3,350,031
Adjusted Current Assets $7,375,330 $3,170,556
Current Liabilities    
  Accounts Payable $4,324,434 $255,433
  Short/Current Long Term Debt $25,009 $0
  Other Current Liabilities $1,726,099 $1,325,671
  Total Current Liabilities $6,075,542 $1,581,104
  Short term debt $25,009 $0
Adjusted Current Liabilities $6,050,533 $1,581,104
Working Capital (adjusted current assets – adjusted current liabilities) $1,481,795 $4,939,483
Net Working Capital $1,324,797 $1,589,452
       
Property Plant and Equipment $714,469 $2,035,559
       
Tangible Capital Employed $2,039,266 $3,625,011
       
Return on Capital Employed Ratio 122% 39%

From above data we can see that ACN has large ROCE ratio as compare to EMC. The reason for this is that ACN is a service firm while EMC is a manufacturing firm. The requirement of property, plants and equipment’s is more for EMC. Under the above analyses an investor will chose ACN over EMC.

There are many advantages of using ROCE. It helps widely to find the quality stocks. ROCE also shows the ability of management in using the investments done by the creditors and investors. In various managerial decisions ROCE serves as basis. As the ROCE ratio can be found for the number of years so it will also tell about the ratio of profitability in the past and the rate of improvement of the business.

 

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