science

Return on capital employed

Return on capital employed is a science topic covered in the lgStudy science library. This page brings together a partial reference excerpt, illustrations, worked examples, real-world applications and a short study plan, so you can understand Return on capital employed rather than just read about it. In short: Return on capital employed is an accounting ratio used in finance, valuation, and accounting. It is a useful measure for comparing the relative profitability of companies after taking into account the amount of capital used.

Key takeaways

Return on capital employed belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Return on capital employed to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Return on capital employed from memory before moving on to harder problems.

Reference excerpt

Return on capital employed is an accounting ratio used in finance, valuation, and accounting. It is a useful measure for comparing the relative profitability of companies after taking into account the amount of capital used.

The formula ROCE = ⁠Earning Before Interest and Tax (EBIT)/Capital Employed⁠ (Expressed as a %) It is similar to return on assets (ROA), but takes into account sources of financing.

Capital employed In the denominator we have net assets or capital employed instead of total assets (which is the case of Return on Assets). Capital Employed has many definitions. In general it is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities (or fixed assets plus working capital requirement). ROCE uses the reported (period end) capital numbers; if one instead uses the average of the opening and closing capital for the period, one obtains return on average capital employed (ROACE).

Application ROCE is used to prove the value the business gains from its assets and liabilities. Companies create value whenever they are able to generate returns on capital above the weighted average cost of capital (WACC). A business which owns much 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.

Drawbacks The main drawback of ROCE is that 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).

See also Cash-flow return on investment (CFROI) Cash surplus value added (CsVA) index Economic value added (EVA) Return on assets (ROA) Return on equity (ROE) Return on invested capital (ROIC)

References

Worked examples

Example 1 — a first encounter with Return on capital employed

Start with the simplest possible case. Write down what Return on capital employed claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Return on capital employed before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Return on capital employed ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Return on capital employed

In research: Return on capital employed appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Return on capital employed in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Return on capital employed is common in secondary-school and first-year university syllabi. It links to neighbouring topics Finance stubs, Financial ratios, Yield (finance), so understanding it makes those chapters shorter.
In everyday life: Look for Return on capital employed outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

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How to study Return on capital employed in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Return on capital employed means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Return on capital employed out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Return on capital employed in simple terms?

Why does Return on capital employed matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Return on capital employed?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Return on capital employed.