Understanding ROCE: A Key Metric for Business Efficiency

What is Return on Capital Emplyed (ROCE)?

ROCE is a crucial metric to assess how efficiently a company is utilizing its capital employed to generate profits. It provides insight into how well the company is using both equity and debt to generate returns for it’s stakeholders.

Here’s a quick breakdown of the formula and its components:

• ROCE = EBIT / Capital Employed

Where:

• EBIT (Earnings Before Interest and Taxes): This measures the operating profitability of a company before considering interest and taxes.
• Capital Employed: This represents the total funds employed in the business, calculated as Total Assets – Current Liabilities. Alternatively, it can be understood as the sum of Equity capital + Non-current liabilities (long-term debt).

Why is ROCE important?

1. Measures Efficiency: ROCE indicates how much return is generated for each dollar of capital employed, making it a critical efficiency metric.
2. Importance in Capital-Intensive Industries: It’s especially useful for comparing companies in industries that require significant investments in assets, such as manufacturing or utilities.
3. Comparison Across Firms: A higher ROCE signifies more efficient use of capital and can be a key differentiator when evaluating companies with similar operations.

ROCE – Limitations

• Unutilized Cash: If a company has large reserves of unutilized cash, it might distort the ROCE figure, making it less meaningful.
• Fluctuations in Capital: Since capital employed can change over time, the timing of the calculation can affect the accuracy of the ROCE.
• Some analysts may choose to calculate ROCE based on the average capital employed based on the average of opening and closing capital employed.

Example: Hindustan Unilever Ltd (HUL) ROCE Calculation

₹ in Crores	Mar-24	Mar-23	Mar-22	Mar-21
EBIT	14,264	13,460	11,980	10,723
Total Assets (A)	78,499	73,087	70,517	68,757
Current Liabilities (B)	12,876	12,028	11,280	11,103
Capital Employed (A – B)	65,623	61,059	59,237	57,654
ROCE (%)	22%	22%	20%	19%

Note: 1 Crore =10 Mn

HUL Data source: Moneycontrol

Observation:

Hindustan Unilever’s ROCE improved from 19% in March 2021 to 22% in March 2024, indicating increased efficiency in utilizing its capital to generate profits.

Conclusion

In essence, ROCE provides a holistic view of how well a company is generating profits from its long-term funding sources (both equity and debt).

Investing ideas:

Companies with rising or stable ROCE tend to be attractive to investors, as they reflect efficient capital management and potential for long-term growth. On the other hand, companies with declining or volatile ROCE might signal inefficiency or difficulties in maintaining profitability.