Historical Background on the ROCE (Return On Capital Employed) Ratio
The ROCE ratio has historically been quoted and represented as a fundamental measure by most industry investors. The Return On Capital Employed (ROCE) ratio is considered by many investors to be the primary measure of profitability. This Return On Capital Employed ratio is then compared to industry benchmark Return On Capital Employed ratios.
What is the ROCE ratio?
ROCE is sometimes referred to in the financial press as the primary measure of profitability. This “primary” measure of profitability is calculated as:
- Return On Capital Employed (ROCE) =((Net profit before interest & taxation) / ( Share capital + Reserves + long-term liabilities)) x 100
Industry investors quote the ROCE ratio as a percentage.
What does the Return On Capital Employed (ROCE) Ratio Mean to Industry and the Investor?
Industry and investors will possibly look at the relative size of the Return On Capital Employed ratio. This is because a high ROCE percentage that a company is profitable.
Why is Return On Capital Employed (ROCE) Considered the Primary Measure of Profitability?
Some investors consider ROCE the primary measure of profitability since it compares the inputs (total capital invested into the company) with the outputs (profits generated by the company).
What are the Key Problems With Return On Capital Employed Ratio Analysis of a Company or an Industry?
Three possible key problems with the Return On Capital Employed (ROCE) percentage are:
- Investors & industry place too much emphasis on the ROCE ratio without carrying out analysis of the supporting key profitability ratios.
- Investors & industry often do not carry out deep fact based comparative analysis with similar companies (eg often different accounting policies are ignored).
- Investors & industry often find it difficult to get industry benchmark ROCE ratios (especially true for unquoted stock).
What are the Secondary Problems with Return-On-Capital-Employed Ratio Analysis of a Company or an Industry?
Possible secondary problems with the Return On Capital Employed ratio percentage include the following:
- ROCE ratios use historical data. Historic data is not always a sound basis for future earnings.
- The ROCE can vary due to short-term influences (eg recent poor historic results driven by one particularly unprofitable contract).