Return On Capital Employed (ROCE) is an important measure of financial productivity or financial efficiency. This is a good measure of how well the business is being run. The higher the value, the better. It's also referred to as the "Primary Ratio".
A company exists to turn hours and money invested into profits. How well it does that is a measure of financial productivity or more often referred to as financial efficiency.
ROCE is an important KPIs in helping to improve your business productivity management.
How can you measure financial efficiency with ROCE?
The formula for ROCE is defined as Operating Profit/Total Capital Employed *100%
ROCE is showing what level of costs are required to drive profitability. The more productive a company is, the higher the retained earnings they'll be to drive further growth.
Total capital employed might include debt, retained earnings or shareholder equity.
How does ROCE differ from Return On Investment (ROI)?
ROI is only concerned with the returns created by a specific investment such as a marketing campaign. ROCE is looking at the returns created by all the costs of running the business including debt.
How does ROCE differ from Return On Assets (ROA)?
ROA is only looking at the returns created by capital equipment such as machines, vehicles and warehouse lifting equipment.
- Investors will use ROCE when researching companies for possible investment opportunities.
- Like all performance metrics, it should be used in conjunction with other KPIs to accommodate possible hidden risks, such as high levels of debt.
- The values needed can be easily obtained from a company's accounts.
- It is best to establish a trend of ROCE over a period of time to accommodate market changes and possible seasonal variations. A high, stable ROCE will show the business is being well managed.
- If a company has high levels of cash reserves that it's not using, this will make the company appear very inefficient when they are included as part of Total Capital Employed.
Download 7 ways Financial Directors can improve business performance.
How to improve ROCE
The higher the revenue and the lower the costs, the better the ROCE. With staff costs being the biggest cost of all, it may be tempting to reduce the headcount or lower the wages to make the company appear more productive or more appealing to investors.
It is this thinking that has contributed to the poor productivity figures of many UK businesses, that lowering costs, especially staff costs will help build a stronger, more profitable business. The thinking is rooted deep in economics where staff are just seen as a labour cost, a cost to be minimised.
With the top-down hierarchy, staff are recruited for a given job, given a job description, annual appraisals and monitored for the hours they start and finish work. This has the effect of making staff work more hours to feel more effective. An expectation is created that those long hours will be lead to a salary increase, promotion or just stop them losing their job.
But in reality, all that happens is the same work just gets stretched over a longer time, people work less hard, they pace themselves to work the long hours needed and so productivity goes down. Longer lunches, casual conversations all stretch the day out so productivity goes down.
The bosses may think they are getting more work completed for their money, that the employee is earning their salary, but in reality, the same work is being stretched out over a longer period, and most likely completed less effectively too.
The Total Capital Employed may include high levels of debt to drive up sales or operating efficiencies, meaning the company may be carrying high levels of risk.
Capital items are depreciated over time meaning companies with older equipment may look more profitable than companies with new equipment.
Return on Equity (ROE)
Another important, perhaps better, financial productivity KPI, Return on Equity, ROE, measures how well the shareholder value (cash essentially) of the company is creating value.
Why is ROE a better performance measure than ROCE?
Because ROE strips out debt from the capital employed to use just shareholder value and looks at net income, not operating profit, it gives a clearer picture of how well the business is being managed.
How is ROE calculated?
Return on Equity (ROE) = Net Income/Shareholder equity * 100
ROE is seen as an important financial KPI as it is only considering stakeholder equity (cash, equipment etc) and is a better measure of how well the assets of the business are being managed.
- If the ROE is high, check to see why. If it is because the shareholder equity is very low, the company may be low on cash. If it is because the revenues are very high, that shows a strong business performance.
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