Return on Capital Employed–Cautious

Posted by L. C. Chong on April 15, 2014

In the last weekend, a reader discussed with me about Return on Capital Employed (ROCE). ROCE indicates how efficiently the company employs capital.
ROCE is used to prove the value the business gains from its assets and liabilities. A business which owns lots of land will have a smaller ROCE compared to a business which owns little land but makes the same profit.
It basically can be used to show how much a business is gaining for its assets, or how much it is losing for its liabilities.
Formula:
ROCE = Net Operating Profit after Taxes/ Capital Employed
Net operating profit after Taxes= EBIT x (1- tax)
Capital Employed = Total Assets – Current Liabilities
Mathematically, it sounds right. One thing we need to keep in mind if we use ROCE. That is it measures return against the book value of assets in the business. As these are depreciated the ROCE will increase even though cash flow has remained the same. Thus, older businesses with depreciated assets will tend to have higher ROCE than newer, possibly better businesses. In addition, while cash flow is affected by inflation, the book value of assets is not. Consequently revenues increase with inflation while capital employed generally does not (as the book value of assets is not affected by inflation)).