Return on Capital Employed
Also written ROCE · Return on Capital Employed (ROCE) · Return on capital
Operating profit as a percentage of all the capital in the business, equity and debt together — the return the enterprise earns before any question of how it was funded or taxed.
In plain language
Return on equity asks what the shareholders earned. Return on capital employed asks what the business earned, on every rupee put to work in it, no matter who supplied that rupee.
That single change — counting debt in the denominator and measuring profit before interest in the numerator — makes the ratio blind to the capital structure. Two companies running the same operation report the same ROCE whether one is funded by equity and the other by borrowing.
How it works
The numerator is EBIT, struck before interest. The denominator includes the debt that the interest is paid on. Borrow more and both stay put, so leverage cannot flatter the ratio the way it flatters ROE.
That is what makes ROCE the value-creation test. Set it against the cost of the capital it employs: a business earning 11% on capital funded at 13% is destroying value every year it grows, however healthy its reported ROE looks.
The formula
ROCE = EBIT ÷ Capital employed × 100
Capital employed = Total assets − Current liabilities
= Shareholders' equity + Long-term debt
A worked example
A speciality chemicals company: EBIT Rs 340 crore, equity Rs 1,200 crore, long-term debt Rs 700 crore at 9%.
Capital employed = 1,200 + 700 = Rs 1,900 crore
ROCE = 340 ÷ 1,900 = 17.9%
Interest = 700 × 9% = 63 PBT = 277
Tax at 25% = 69 PAT = 208
ROE = 208 ÷ 1,200 = 17.3%
Now change nothing about the business. The company borrows another Rs 700 crore and buys back an equal amount of equity. Operations, assets and EBIT are untouched; capital employed is still Rs 1,900 crore.
ROCE = 340 ÷ 1,900 = 17.9% ← unchanged
Interest = 1,400 × 9% = 126 PBT = 214
Tax at 25% = 54 PAT = 160
ROE = 160 ÷ 500 = 32.0% ← nearly doubled
ROE rose from 17% to 32% without the business improving by one rupee. ROCE did not move. That is the whole argument for looking at both.
Why NISM asks about it
Chapter 8 (Company Analysis – Financial Analysis) covers ROCE alongside ROE and RONW. The recurring question is which profitability ratio is unaffected by capital structure — ROCE — and computations that hand you a balance sheet and expect you to build capital employed correctly. It also underpins the industry-quality argument in Chapter 6.
Common exam traps
- ROCE is pre-tax and pre-interest; ROE is post-both. They sit at different levels of the P&L, so the two percentages are not directly comparable — only their gap is informative.
- Capital employed excludes current liabilities but includes long-term debt. Subtracting all liabilities gives you equity, which is a different ratio.
- A capex year depresses ROCE unfairly — the new plant enters the denominator long before it contributes to EBIT.
- Compare ROCE only within an industry, and always against the cost of capital. A 14% ROCE is excellent in utilities and poor in software.
Check yourself
1.Which of the following measures the ability of a company to satisfy its short-term obligations as and when they come due?
- a)Current ratio
- b)Return on equity
- c)Return on capital employed
- d)Inventory turnover ratio
Show the answer
Answer: (a) Current ratio
The current ratio — current assets divided by current liabilities — is the liquidity measure. It is also known as the working capital ratio. The stricter version is the quick ratio, which removes inventories because they cannot be converted to cash immediately.
ROE and ROCE are return ratios: they measure productivity of capital, not the ability to pay bills. Inventory turnover is an efficiency ratio: how many times inventory is rolled over.
One caution the workbook adds and the exam likes: a current ratio below 1 is not automatically bad. A company that takes cash on sales and pays suppliers on credit will show one, and that is a very good situation in which the company's working is funded by its customers.
2.A business has a net-worth of ₹1,00,000, debt of ₹1,00,000, market capitalisation of ₹5,00,000, no cash, and a ROCE of 45%. What return does an investor buying at this price actually earn on the money invested?
- a)45%, since that is the return the business generates
- b)15%, because EV is three times capital employed
- c)22.5%, because the investor funds half the capital
- d)9%, because the market capitalisation is five times net-worth
Show the answer
Answer: (b) 15%, because EV is three times capital employed
Work through the two numbers separately.
Capital employed = Net-worth + Debt = 1,00,000 + 1,00,000 = ₹2,00,000 EV = Market cap + Debt − Cash = 5,00,000 + 1,00,000 − 0 = ₹6,00,000 EV to capital employed = 6,00,000 ÷ 2,00,000 = 3 times
The business earns 45% on ₹2,00,000, which is ₹90,000 of EBIT a year. You are paying ₹6,00,000 for it. So your return is 90,000 ÷ 6,00,000 = 15% — or simply 45% ÷ 3. As the workbook puts it, the money would generate only one third of this ROCE, i.e., 15%.
Option A is the trap, because 45% is the figure printed in the question. It is the return the business earns on its own capital. It is not the return you earn, because you bought the enterprise at three times the capital employed.
The practical use of this arithmetic is a price ceiling. If the investor wants a 20% minimum return on capital, he would not be willing to pay an EV of more than 45 ÷ 20 = 2.25 times the employed capital — ₹4,50,000. It converts a required return straight into a maximum price, without any argument about whether the company is "good".
3.Which statement about FDI and FPI is CORRECT as per the workbook?
- a)FDI is the passive form of investment and FPI is the active form
- b)FPI investors participate in the management and decision making of investee companies
- c)FDI is long term and stable, while FPI money is considered hot money that can be pulled out at any time
- d)There are no limits on FPI holding in the paid-up capital of Indian companies
Show the answer
Answer: (c) FDI is long term and stable, while FPI money is considered hot money that can be pulled out at any time
The workbook says "While FDI is long term in nature and stable capital coming into the business, FPIs money is considered as hot money as they can pull out the money at any time which could create systemic risk for the economy."
Option A reverses the pair — FDI is the active form where investing entities participate in decision making and drive the businesses; FPI is the passive form.
Option B contradicts the definition of FPI directly: it is investment in equity or bond markets without any involvement in management participation in the decision making process.
Option D is wrong because the workbook states there are upper limits on the individual and combined holding by FPIs in the paid-up capital of Indian companies.
Where this is taught
Free preparation for NISM Series XVRelated terms
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Core working capitalInventory plus trade receivables minus trade payables — the money permanently trapped in the operating cycle, stripped of cash and borrowings, which have nothing to do with trading.
- EBITDAProfit from running the business, measured before interest, tax, depreciation and amortisation — so before how the company is funded and how it accounts for its assets.
- Return on EquityProfit after tax as a percentage of shareholders' net worth — what the company earned on the money its owners have left in it.
- Porter's Five ForcesMichael Porter's framework for judging how much profit an industry can sustain, through five competitive pressures: rivalry, new entrants, substitutes, and the bargaining power of suppliers and of buyers.