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March 4th 2019

Return on capital employed - what it is and why it matters

Business owners are spoilt for choice when it comes to selecting financial ratios, KPI’s and other measures to track their business’s financial performance and position.

However, there are only so many hours in the day, so it is important to try to narrow down and isolate which specific measures are of most significance and thus needing to be monitored regularly.

Return on capital employed (ROCE for short) is, perhaps, the ultimate measure of how a small business generates value and I would suggest should be on any business’s list of top KPI’s to measure. But how is ROCE calculated – and what does it actually mean?

Essentially, ROCE tells us how effective a company is at generating returns for investors. ROCE is therefore of prime interest to a business’s owners – and potential future investors, too.

Because it is expressed in percentage, rather than absolute value terms, ROCE tells us nothing of the scale of the business – but it does tell us how good the business is at generating profits. Therefore it also enables the user to compare the profitability of different companies, regardless of their relative size. ROCE also provides comparability regardless of the way in which different companies are financed.

Calculating ROCE is straightforward; it is simply operating profits expressed as a percentage of total capital. Operating profits are the profits a company generates, before interest costs and taxation. Total capital is the sum of equity and long term debt. Simple.

There are two underlying components to ROCE, both equally important:

  1. Productivity – how good is the business at generating revenue, using the assets at its disposal?; and
  2. Profitability – how good is the business at turning the revenue into profits?

Both of these elements should also be measured. Productivity can be tracked using the Asset Turnover ratio, simply calculated as turnover divided by total capital. Profitability can be measured using the Operating Margin, calculated as operating profits divided by turnover, expressed as a percentage.

Illustrating the link between ROCE, productivity and profitability, ROCE can be found by multiplying Asset Turnover by Operating Margin. The three ratios – ROCE, Asset Turnover and Operating Margin together are therefore sometimes termed the “ROCE Triangle”.

A simple example:

For the year ended 31 December 2018 ABC Ltd reported the following:

  • Turnover £2m
  • Operating profit £100k
  • Total capital £1m

ROCE is 100k / £1m expressed as a percentage = 10%

Asset Turnover is £2m / £1m = 2

Operating Margin is £100k / £2m expressed as a percentage = 5%

ROCE can also be found by multiplying Asset Turnover by Operating Margin, i.e. 2 x 5% = 10%.

If this all sounds like too much work, consider how you will define and measure what really matters in your business.

These days help is at hand in the form of advanced software like Futrli, which enables Quickbooks and Xero users to actively track and report on key measures on a near “real time” basis, with comparatively little effort. Just define what needs to be measured, set it up on Futrli, and the rest is pretty easy.

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