Return on Capital Employed (ROCE)

Summary

This video introduces the Return on Capital Employed (ROCE), a key financial ratio used to assess business performance by measuring profitability relative to capital invested. ROCE is calculated by dividing a company's operating profit by its total capital employed, which includes equity and non-current liabilities. The video also explains how ROCE is a useful tool for comparing financial performance across businesses and industries, and for tracking changes over time. Additionally, it highlights how ROCE can vary between sectors depending on capital intensity and profitability.

Takeaways

• 💡 Return on Capital Employed (ROCE) is a key financial ratio used to assess a company's profitability relative to its capital investments.
• 💼 Businesses invest in various assets like inventory, warehouses, and production facilities to generate profits, and ROCE measures how well these investments are used.
• 📊 ROCE is a useful metric for comparing the profitability of different companies or industries, providing insights into how efficiently they are using their capital.
• 🔢 The formula for ROCE is: Operating Profit / (Total Equity + Non-Current Liabilities) x 100, expressing the result as a percentage.
• 🏭 ROCE can vary significantly between industries; for example, capital-intensive industries like manufacturing tend to have lower ROCE compared to service sectors.
• 📉 ROCE helps assess not only current profitability but also track changes over time, indicating whether a company's capital is being used more efficiently.
• 📊 A higher ROCE indicates better profitability relative to the capital employed, while a lower ROCE suggests less efficient use of capital.
• 🏢 Company X had a higher ROCE (22.8%) compared to Company Y (18.7%) despite having lower operating profits, due to having less capital employed.
• 📋 ROCE is calculated using publicly available financial information from a company’s balance sheet (equity and liabilities) and income statement (operating profit).
• 🔍 ROCE is commonly used in investment appraisals and financial analysis to set benchmarks or target returns for specific projects or investments.

Q & A

What is the main purpose of the Return on Capital Employed (ROCE) ratio?

The main purpose of the Return on Capital Employed (ROCE) ratio is to assess how effectively a business is turning its capital investments into profit. It measures the profitability relative to the amount of capital invested in the business.

Why is profit considered the main return from business activities?

Profit is considered the main return from business activities because it represents the difference between total revenues and total costs, which is the primary goal for businesses after making investments in operations, inventory, or other assets.

What types of investments do businesses typically need to make to generate profit?

Businesses typically need to invest in inventories, warehouses, production facilities, or distribution capabilities, depending on the nature of the business, to generate profit.

How is the ROCE ratio calculated?

The ROCE ratio is calculated by dividing the operating profit of a business by the total capital employed, which is the sum of total equity and non-current liabilities. The result is then multiplied by 100 to express it as a percentage.

What financial statements are used to find the data needed to calculate ROCE?

The operating profit is found in the income statement (or profit and loss account), while total equity and non-current liabilities are drawn from the balance sheet of the business.

Why might ROCE vary between industries?

ROCE may vary between industries because some industries have high capital investments but low profit margins, resulting in a lower ROCE, while others, such as the service sector, have less capital intensity and higher profit margins, leading to a higher ROCE.

How can ROCE be used to evaluate a business over time?

ROCE can be used to evaluate a business over time by monitoring whether the ratio is increasing or decreasing. A rising ROCE indicates more profitable use of capital, while a falling ROCE may suggest less efficient use of resources.

Why might a business with higher operating profit have a lower ROCE compared to a competitor?

A business with higher operating profit might have a lower ROCE compared to a competitor if it has more capital employed. A larger amount of capital reduces the relative return, even if the absolute profit is higher.

In what ways is ROCE useful for comparing businesses?

ROCE is useful for comparing businesses because it provides a standardized way to assess how efficiently competitors are using their capital to generate profit, making it a valuable tool for benchmarking within an industry.

What limitations does ROCE have as a financial measure?

ROCE has limitations because it is based on a snapshot of financial information from a specific time, which might not reflect ongoing or future performance. Additionally, industry differences and varying levels of capital investment can make it difficult to compare across sectors.