What is Return on Capital Employed?

The return on capital employed is probably not a metric that many small companies calculate, but it can be very revealing about financial health. In some prior postings we looked at several ways of measuring a business’s return. Among those were return on assets and return on equity (see Two Measures of Financial Return). We also look at return a different way in the posting Debt Coverage. See those postings if you want to know more about these very useful measurements.

It is important to understand that there are two main sources of capital; one is owners’ equity and the other is debt. Any undistributed earnings flow into owner equity, so it impacts the calculation of return on equity. Having already examined the importance of return on equity, let’s now turn to return on capital employed.

Return on Capital Employed Calculation

As noted above, the capital employed in a business has two components; owners’ equity and debt. So the return on capital employed would be calculated as follows:

Return on Capital Employed (ROCE) = EBIT / Average Capital Employed

Note that this is expressed as a percentage. In the formula EBIT stands for the annualized earnings before interest and income tax. Average capital employed is calculated by using the average of the beginning and ending debt plus the average of the beginning and ending equity.

As to what is recognized as debt, there is some leeway, but generally is would be debt that is financed (that is, pays interest), so it would then be short-term loans (such as a line of credit), along with both the current and long-term debt (an example being equipment loans). Note that short-term debt does not include things like accounts payable and accrued expenses. Of course, if a company has found it necessary to convert some of its accounts payable to a note payable to the vendor, then it would be included in the calculation.

An Example

Using the following hypothetical data we can see how the calculation is made:

EBIT = $300,000

Beginning Debt = $300,000

Ending Debt = $250,000

Average Debt = ($300,000 + $250,000) / 2 = $275,000

Beginning Equity = $700,000

Ending Equity = $900,000

Average Equity = ($700,000 + $900,000) / 2 = $800,000

So, the calculation of return on capital employed is:

ROCE = EBIT / Average Capital Employed

ROCE = $300,000 / ($275,000 + $800,000)

ROCE = 27.9%

Why it Matters

If you have also calculated the return on equity, the calculation of the return on capital employed helps you see the impact of leveraging the business via the use of debt. A company may have very little in the way of equity and the earnings return that only considers this can be misleading. On the other hand, if the return on capital employed is significantly less than the return on equity, it could be a sign that the company is overly leveraged. A significant event might reduce the profitability enough that it could become difficult to service the debt obligations. In the example above the return on equity is:

ROE + $300,000 / $800,000 = 37.5%

When debt is added into the calculation you can see that the return is reduced from 37.5% to 27.9% or 9.6%. Management has to judge if the leverage obtained via debt is producing as much return as they anticipated. When making this assessment, management must also consider if the net EBIT would have been reduced enough when no debt was used that the ROE was dramatically reduced. That is because sometimes, even though the ROCE may be considerable lower than the ROE, it may in fact be benefiting the ROE percentage by producing significant additions to the EBIT.

I recommend that you use multiple ways of measuring returns, but return on capital employed is one that you should get familiar with. It can warn you of the dangers of using excessive leverage, especially if you make this calculation using estimated EBIT before actually incurring debt.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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