What is ROCE and how is it calculated - The most comprehensive guide
Need to Make strategic decisions - Use ROCE to guide you through
Define
Return on Capital Employed, abbreviated as ROCE, is ratio used to understand company’s capital efficiency, i.e. how efficient is the firm in generating profits from the capital it invests in the firm.
What Formula?
There are several formulas to calculate ROCE, and it depends on what one wants to use it for, what level of details are given and level of details required. Earnings before Interest and Tax/Capital Employed
What Components?
A. Capital Employed from Asset side of Balance sheet
Capital employed = Total Assets – Current Liabilities, or
Capital employed = Net Fixed Assets + Net Working Capital, where
Net Fixed Assets = Gross PP&E + Additions – Disposals - Depreciation and Impairment
B. Capital Employed from Liability side of Balance sheet
Capital Employed = Shareholders Equity or funds + Total Debt or Net debt + Deferred Tax Liability
Or, Net worth + Net Debt
Or
Add:
If Lease is considered as Debt
Where Shareholders Equity can be detailed as:
Most comprehensive formula
Notes
1. In case of US GAAP, remember: Add Operating Lease Liabilities and Current portion of Operating Lease to total Debt
2. Shareholders equity means Equity attributable to Parent i.e. do not add Non-controlling Interest
Earnings Before Interest and Tax
EBIT is what is presented in the annual report as Operating profit or
EBIT = Adjusted EBIT, where adjusted EBIT calculated after removing one-time non-recurring and non-operating items of expense and income
Always remember
1. Add back Non-recurring & one-time expenses, Unusual and Non-operating expenses
Less Non-recurring & one-time expenses, Unusual and Non-operating incomes or gains
Where can I find them - Financial Statement Linkages?
Real Company Analysis - SGS Group
Let’s take example, of SGS Group, a Swiss company engaged in Testing, Inspection and Certification business. We have taken numbers from annual reports from 2016 to 2022. The annual reports can be found at https://www.sgs.com/en/investor-relations
Return on Capital Employed (CHF Million)
Please feel free to pick your poison on which formula to use to calculate Capital Employed. The idea is simply to calculate total debt.
EBIT
ROCE = Adjusted EBIT / Capital Employed
How to Interpret?
As we can see from the example above, for every CHF 1 company employs it is able to earn operating profit on an average of 21 percent or in other words how much operating income is generated for each CHF 1. Also, important is comparison with some average or benchmark indicator.
Comparison can be done in the following ways:
1. Temporal Comparison, i.e. time series trend analysis
2. Comparison with Industry benchmark
3. Comparison with Industry Average or close peers / competitors
Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison.
1. Trend Analysis
As can be seen from our example that SGS group has consistently performing with ROCE of above 20% except for 2020 with ROCE falling to 16% due to covid effect.
2. Comparison with Industry Average or close Peers:
If you compare SGS group with its close peers like Intertek and Mistras it has faired better than Mistras but not with Intertek.
Mistras ROCE
Intertek ROCE
Comparison with Close Peers
But if we compare it with average ROCE of close peers, we find SGS Group has outperformed them by quite a margin, as seen from the table above.
It is important to understand that when we compare ratio with peers/competitors, the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared.
Also, when comparing peers’ careful consideration should be given about the share of fixed assets in total assets of the firm. For firms with high fixed asset as percentage of Total assets will have lower ROCE.
What Strategic Implications
Firms that have ROCE consistently above Weighted Average Cost of Capital (WACC) have sustainable competitive advantage. If we take the numerator of the ROCE ratio which is EBIT and break it further, we see it dependent on Price, Volume of product sold or frequency of services rendered and cost of service. Firms that can charge premium price or have lower costs will consistently perform better in terms of ROCE compared to WACC.
How to forecast?
To forecast ROCE we need to forecast Revenue, Operating Costs, Total Debt, and Shareholders funds. Shareholders funds are divided into key components for forecasting:
1. Share Capital
2. Treasury Shares
3. Additional Paid-in Capital
4. Share Premium
5. Reserves
6. Retained Earnings
1. Share capital can be forecasted using straight line method. If you want to get complex, then use additional funding requirement schedule. We need to create and 3-statement model to create such a schedule.
We need to assume about what Debt equity ratio to find additional share capital or debt. We can also use the optimal capital structure model to forecast it.
2. Treasury Shares
Treasury Shares is buy-back of shares by firms. To forecast it we can use either straight line method or look at for clues in annual reports Management Discussion & Analysis part where they discuss their plan for buy-back. But it more likely than not firms do not announce it in advance as it influences stock markets.
3. Additional Paid-in Capital
Additional Paid-in capital is additional capital raised by companies. This is similar to share capital we do not need to forecast this and use the share capital schedule.
4. Share Premium
If you have additional capital and assume to place at premium forecast, it using share capital requirement and premium that you will charge per share. Otherwise, use straight line forecast.
5. Reserves
Reserves are divided into three types:
a. General Reserve: Profits retained in business
b. Specific Reserve: Like Debenture Redemption Reserve are type of reserve is maintained for a specific purpose
c. Capital Reserves: Reserves created for specific purpose and can be used for that reason only
Use straight line method to forecast reserves if details about specific purpose for which reserves were created not available.
6. Retained Earnings
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