Return on Capital Employed (RoCE) in Financial Analysis

In this segment, our faculty Marie-lys will explain the next key metric used in analysing the performance of the operations of a company, i.e., return on capital employed (RoCE). 

As you learnt in this video, return on capital employed (RoCE) is the most comprehensive indicator of the operating performance.

Return on capital employed helps in determining the resources employed in generating the operating margin. The key points related to Return on Capital Employed are:

• It shows the operating profit per unit of capital employed. 

• It can be calculated as follows:
  $ReturnonCapitalEmployed=\frac{Operatingincome}{Capitalemployed}$

The Return on Capital Employed and operating margin are interlinked. Their relationship can be understood using the following equation:

This equation reveals the following drivers of RoCE:

In the next segment, you will learn about return on average capital employed (RoACE).

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Transcript of the Video: 

We just had a look at the operating margin. This is a very helpful indicator, easy to compute, easy
to understand, easy to discuss with peers.

However, it isn't really sufficient. And the operating margin must be challenged against the amount
of resources that was involved to generate that same operating margin.

That leads us to come shooting a second metric, which would give us a more comprehensive view
of the performance of the operations.

And that second metric would answer this question, how much profit was delivered by the
operations out of $1 of resources utilised? That would be the return on capital employed. Indeed, we already said that the resources involved to run the operations are computed inside the capital employed.

So, if you want to access the return on capital employed, we're going to look at the operating
income, the profit from the operations.

And divide it by the capital employed, that is, property, plant and equipment, plus the operating
working capital. In my case here, I come to a 22.5% return on capital employed. So, we just came here to the most comprehensive measure of the performance of the operations.

Then let's go deeper in the analysis. There must be a link between the RoCE and the operating
margin now. Intriguingly, I feel like the more profitable my business is, the higher my return on capital
employed. So, let's do something together. Let's do a bit of math. Let's start from the RoCE formula and let's
split it into two factors.

Look at what I'm doing here. I'm taking the operating income, and I divide and multiply by the sales
revenue. And then I finally divide by the capital employed. You may feel like what's the point, that changes
nothing. Yes, it does. It changes many things because now I have highlighted the two most important
drivers of performance at operating level.

If you want to have a top-notch performance at operating level, i.e., if you want the maximum
return on capital employed, you need to max up these two factors.

The first one, we already know it. This is the operating margin. So, with $1 of sales revenue, we
wants to be able to keep as many cents of profit from the operations.

So, that's the profit margin dimension of the RoCE. Then there is a second dimension. What is this
second factor telling us? The second factor, we often call it capital employed turnover.

But what does it mean? Actually look at it. It represents how many dollars of sales we were able to
generate with $1 of capital employed.

The name of the game is, hey, we're granted $1 of capital employed, so we need to generate as
many dollars of sales we can with this sole dollar of capital employed we've been granted.

There is an efficiency idea here. We must be as efficient as possible. That is, generate as much
business as we can, given the resources we've been granted.
So, in order to be highly performing, a company's operations need at the same time to look for the
maximum margin and the maximum efficiency.

Try to max up both factors at the same time. I know some of you need numbers to realise what's
happening. So, look at these numbers here.

Here, my company had a fairly low operating margin. See the operating margin was only 5%.
That's not much. But look at the capital employee turnover, 4.5. It means that whenever I'm granted $1 of capital
employed, I can generate $4.5 of sales.

Well done, sky high efficiency. At the end of the day, combining average margin with a top-notch
efficiency, I'm able to deliver a very good RoCE at 22.5%.