Our next profitability ratio, return on capital employed, or RoCE indicates the efficiency and effectiveness of a company’s capital investments.
Return on capital employed should always be higher than the rate at which the company borrows, it should earn more than the cost of funds it applies in the business. The company may face liquidity issues if the interest costs on its debt are more than the return gained on the employed capital.
For a company that has fluctuating capital, a more suitable ratio would be return on average capital employed, which uses the average of opening and closing capital employed during a given period of time. Simply substitute total assets and current liabilities for their averages.
Below is an example of the return on capital employed formula in action:
Bobs plumbing company reported a operating profit of $ 200 000. Bob also claimed he had $150 000 in total assets and $ 60 000 in total liabilities.
Return on Capital Employed = $200 000 / $150 000 – $60 000
RoCE = 2.22
What this means, is that every dollar that bob invested in employed capital, he seen a return of $2.22. This number is higher than normal, but the example is to just show you how to punch numbers into this simple formula.
While all these profitability ratios throughout these articles provide valuable insight into a company’s financial performance during the operating cycle, the analyst should be aware of manipulation techniques used for distorting the income statement before drawing any conclusions based upon these profitability ratios.