Return on capital employed: formula and what it tells you

Return on capital employed, usually shortened to ROCE, is a percentage that shows how much operating profit a business earns from the capital invested in it. It answers a simple question: for every pound the business has tied up in its long-term operations, how many pence of operating profit come back each year?

The British Business Bank’s glossary describes operating profit as the profit or loss a company makes that reflects how a business is performing. ROCE relates that profit to the size of the business’s capital base, so a small firm and a large one can be compared on the same footing.

It is a ratio, not a rule. There is no official UK definition that every business must follow, so two sources can calculate it slightly differently. The sensible habit is to write down which version you used and keep to it.

The most common formula divides operating profit by capital employed and multiplies by 100: ROCE = operating profit (EBIT) ÷ capital employed × 100. EBIT means earnings before interest and tax, which is operating profit before the cost of borrowing and before Corporation Tax.

Capital employed is usually worked out as total assets minus current liabilities. Another way to reach the same figure is equity plus long-term liabilities, because a balance sheet balances. Either way you are measuring the money the business has available for the long haul, funded by owners and by lenders.

To calculate ROCE you take operating profit from the profit and loss account, work out capital employed from the balance sheet and divide one by the other. The numbers below are round and made up, to show the arithmetic only.

In this illustration the business earned about 17 pence of operating profit for each pound of capital employed. Whether that is strong depends on the sector, the year and the alternatives open to the owners, which is why the next sections matter.

Both inputs come from your annual accounts or management accounts: operating profit sits in the profit and loss account and the balance sheet holds the assets and liabilities. The British Business Bank defines a balance sheet as a summary of a company’s assets, liabilities and capital at a given point in time.

• Operating profit: see our guide to the profit and loss account, and check whether interest and one-off items have been separated out.
• Assets and liabilities: our guide to the balance sheet shows how current and long-term items are grouped.
• Related measure: EBITDA adds depreciation and amortisation back to operating profit, so it is not the same as the EBIT used here.

Some people use the average of opening and closing capital employed, because the balance sheet is only a snapshot. That is a reasonable refinement if the business changed a lot during the year. Just use the same method every time.

A good ROCE is one that compares well with your own past results, with similar businesses in your sector and with what it costs you to fund the business. There is no single percentage that is good for everyone, and this post does not offer one.

These comparisons give the figure meaning:

• Against previous years: a rising trend usually matters more than one result.
• Against the cost of funding: if borrowing costs more than the business earns on its capital, growth funded by debt can squeeze the business.
• Against similar businesses: a capital-heavy business such as a manufacturer holds more assets than a services firm, so the two are not directly comparable.

Read the figure alongside profit margins and cash flow. A business can show a respectable ROCE and still be short of cash, because ROCE is built on accounting profit and not on cash received.

ROCE looks at operating profit against all long-term capital, whereas other ratios pick a narrower profit or a narrower pool of money. The British Business Bank’s glossary describes return on investment (ROI) as the earning power of an asset or activity, measured as a ratio of net income to operational cost.

Interest is the link to lending. Because ROCE is measured before interest, it shows what the business earns before paying lenders. Our guide to the interest cover ratio shows the next step: whether that profit comfortably covers the interest charged on borrowing.

ROCE can mislead when the inputs are distorted, so treat it as a prompt for questions, not a verdict. Common problems include:

• Old assets carried at low book values can make ROCE look flattering, because the capital employed figure is small.
• A big one-off gain or cost in operating profit moves the result for a year without changing how the business really trades.
• A snapshot balance sheet taken at a seasonal low or high does not represent the year.
• Negative or very small capital employed makes the percentage meaningless.

Different businesses also define the inputs differently, so a ROCE quoted by someone else may not match yours. Rebuild any comparison figure from the same accounts and the same definitions.

ROCE can help you judge whether borrowing is worth it, but it is only one input, and lenders set their own criteria. It matters most when you ask whether a loan will earn more than it costs: a business that earns a lot on each pound it invests can have more room to take on funding than one that earns little.

Lenders usually look at several measures together, including cash flow and affordability, rather than ROCE alone. When you weigh up a loan, compare total cost as well as the headline rate: our guide on how to compare business lenders covers that, and the right type of asset finance or loan depends on what the money will earn.

Capzy is a credit broker, not a lender, and is paid by the lender. We do not calculate ratios for you or give accounting or tax advice, so ask your accountant to check the figures you rely on. What we can do is introduce you to lenders that offer the finance you need.

You can check your funding options with a soft search that does not affect your credit score. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. The lender directory shows who provides which products.