5.1.5 Return on capital employed
Return on capital employed (ROCE) is a primary ratio used by investors and shareholders to evaluate the overall performance of the company. It compares the profit earned by the company with the capital employed to generate that profit.
ROCE is used to assess the value the business creates from the use of its assets and liabilities. If an investor has to choose between two companies with similar levels of capital employed, they will choose the business that generates the highest level of return.
The importance of capital employed
Shareholders invest their capital in a company in order to secure the best possible return on the risk that they take in investing their money. Long-term lenders lend money to a company and this is known as loan capital. Unlike shareholders, they do not participate in the growing profits of a business. Their concern is to receive payments of interest and, ultimately, the repayment of the original capital. Both share capital and loan capital are invested in assets, non-current and current, in order to generate an operating profit. This profit figure is most meaningful when it is given as a return on total capital employed in the business.
An investor needs to know what return is being generated by the capital invested in the business. This rate of return can then be compared with the returns that could be generated by investing in various other investment options. However, it is important to note that not all investments offer the same rate of return. Investments in some options will be riskier and offer better returns, while investing in other options might be less risky and offer lower returns. An investor will compare investments with similar risk profiles and choose the one which offers the best return on capital. What constitutes a good return will therefore be dependent on comparisons – with previous years and with other companies having similar risk profiles and in the same industry. In well-established businesses, this ratio will remain fairly constant over the years or may show a slightly increasing pattern from year to year.
Management also finds this ratio very useful because it shows the return generated on assets (which are presumed to be under management control) and evaluates if the operating profit from core activities of the business is sufficient to generate a return on the equity and finance debt in the business. Explanations might be sought if there are any abrupt changes in the ratio over the years. These changes might be caused either by fluctuations in the level of profitability or by changes in the capital structure of the company.
It is important to note that the definitions and formulas for ROCE vary and there is no standard governing how it is defined and calculated by a business entity. For example, capital employed might be expressed as net assets, that is, equity plus long-term loans (or total assets minus current liabilities). Alternatively, it might be defined as total assets, that is, equity + long term debt + current debt. No matter which definition of capital employed you use, consistency in the use of that definition is the key when you are analysing data over several years and/or across companies.
Below is the calculation of the return on capital employed for Remote Sensors Plc for 2025, using the following formula for ROCE:
It is important to mention that lease liabilities might also be added when calculating debt. However, in this course, lease liabilities are excluded when calculating current as well as non-current debt.
The calculations of ROCE follow for Remote Sensors Plc for 2023, 2024 and 2025, where capital employed is defined as equity + non-current debt + current debt. This definition of capital employed will be used in this course.
| 2025 | 2024 | 2023 | |
|---|---|---|---|
| £ | £ | £ | |
| Equity | 41,980 | 40,155 | 37,790 |
| Non-current debt | 5,600 | 2,990 | 2,580 |
| Current debt | 1,000 | 1,745 | 1,900 |
| Capital employed | 48,580 | 44,890 | 42,270 |
| Operating profit (PBIT) | 4,120 | 3,515 | 3,484 |
| ROCE | 8.48% | 7.83% | 8.24% |
In the case of Remote Sensors Plc, you may observe a decline in ROCE from 2023 to 2024; however, it increased again in 2025. You may observe that the capital employed by the company has been consistently increasing from 2023 to 2025. However, the company has not been able to maintain a consistent increase in ROCE. Therefore, the analyst must investigate the possible reasons for a decline in ROCE in 2024 and how management succeeded in improving returns in 2025. It is also important to compare this ratio with other competitors within the industry to gain a holistic picture of the company’s performance.
Activity 6 provides you with an opportunity to practise calculating ROCE.
Activity 6 Calculating ROCE
Read the data on debt and operating profit for Marks & Spencer Group Plc from 2018 to 2022 (extracted from Fame) and answer the following questions.
- a.Calculate ROCE for 2018 to 2022.
| 2022 | 2021 | 2020 | 2019 | 2018 | |
|---|---|---|---|---|---|
| £m | £m | £m | £m | £m | |
| Equity | 2,917.90 | 2,283.00 | 3,708.50 | 2,681.00 | 2,956.70 |
| Non-current debt | 3,561.00 | 3,659.90 | 3,865.90 | 1,279.5 | 1,670.6 |
| Current debt | 247.2 | 432.8 | 316.6 | 513.1 | 125.6 |
| Operating profit | 572.2 | (30.7) | 254.8 | 162.4 | 156.5 |
| ROCE |
Comment
| 2022 | 2021 | 2020 | 2019 | 2018 | |
|---|---|---|---|---|---|
| £m | £m | £m | £m | £m | |
| Equity | 2,917.9 | 2,283.0 | 3,708.5 | 2,681.0 | 2,956.7 |
| Non-current debt | 3,561.0 | 3,659.9 | 3,865.9 | 1,279.5 | 1,670.6 |
| Current debt | 247.2 | 432.8 | 316.6 | 513.1 | 125.6 |
| Capital employed | 6,726.1 | 6,375.7 | 7,891.0 | 4,473.6 | 4,752.9 |
| Operating profit | 572.2 | (30.7) | 254.8 | 162.4 | 156.5 |
| ROCE | 8.51% | (0.48%) | 3.23% | 3.63% | 3.29% |
- b.How would you interpret the changes in ROCE over these years?
Feedback
There were no significant changes in ROCE from 2018 to 2020. Although the company’s operating profit increased in 2020, there was also an increase in the company’s capital employed. ROCE fell drastically in 2021, when the company made a loss and the ROCE was negative. The Covid-19 pandemic was probably one of the reasons for this fall. In 2022, the company made an unusually high profit, resulting in a very high ROCE. It may signify that the company made a recovery from the disruptions caused by the pandemic.
Activity 7 provides you with an opportunity to calculate and interpret the profitability ratios using the financial statements of Next Plc and thus apply the concepts learnt in this session so far to interpret real company data.
Activity 7 Calculating profitability ratios
Access Next Plc accounts [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] for the years ending 2022 and 2021. Look at the contents page of the annual report and locate the ‘Consolidated Income Statement’ and ‘Consolidated Balance Sheet’ to obtain the relevant financial figures for calculating the ratios. Then answer the following questions.
- a.Calculate the following ratios to assess their profitability:
- Gross profit margin
- Operating profit margin
- Return on capital employed.
Use the notes to the financial statements to retrieve more accurate or additional figures.
Use the following spreadsheet to carry out your analysis.
| Workings | 2022 | 2021 | |
|---|---|---|---|
| £m | £m | ||
| Total revenue | |||
| Cost of sales | |||
| Gross profit | |||
| Operating profit (PBIT) | |||
| Current debt (bank loans, overdrafts + bonds) | |||
| Non-current debt (corporate bonds) | |||
| Total debt | |||
| Equity | |||
Capital employed = (equity + non-current debt + current debt) |
|||
Gross profit margin = (GP/Revenue) × 100 |
2022 = |
||
2021 = |
|||
Operating profit margin = (Operating profit/Revenue) × 100 |
2022 = |
||
2021 = |
|||
| ROCE = Operating profit/Capital employed | 2022 = |
||
2021 = |
|||
Comment
| 2022 | 2021 | |
|---|---|---|
| £m | £m | |
| Total revenue | 4,625.9 | 3,534.4 |
| Cost of sales | 2,625.3 | 2,231.7 |
| Gross profit | 1,972.0 | 1,247.9 |
| Operating profit (PBIT) | 905.4 | 444.5 |
Current debt (bank loans and overdrafts + corporate bonds) |
233.1 | 419.4 |
| Non-current debt (corporate bonds) | 815.7 | 837.0 |
| Total debt | 1,048.8 | 1,256.4 |
| Equity | 1,010.0 | 660.9 |
Capital employed = (equity + non-current debt + current debt) |
2,058.8 | 1,917.3 |
Gross profit margin = (GP/Revenue) × 100 |
42.63% | 35.31% |
Operating profit margin = (Operating profit/Revenue) × 100 |
19.57% | 12.58% |
ROCE = Operating profit/ Capital employed |
43.98% | 23.18% |
Workings
Gross profit margin
2022 = (1,972.0/4,625.9) × 100 = 42.63%
2021 = (1,247.9/3,534.4) × 100 = 35.31%
Operating profit margin
2022 = (905.4/4,625.9) × 100 = 19.57%
2021 = (444.5/3,534.4) × 100 = 12.58%
Return on capital employed
2022 = (905.4/2,058.8) × 100 = 43.98%
2021 = (444.5/1,917.3) × 100 = 23.18%
- b.How would you interpret the changes in the ratios calculated above?
Feedback
There is an improvement in the gross profit margin of the company from 35.31% in 2021 to 42.63% in 2022. This improvement in gross profit margin was caused by an increase in the total revenue of the company in 2022, which could be due to better marketing, pricing strategy or sales mix. Operating profit margin also increased from 2021 (12.58%) to 2022 (19.57%). This implies that the company not only increased its revenues but also successfully controlled its costs. You may also observe a significant increase in ROCE from 23.18% in 2021 to 43.98% in 2022. Overall, all the ratios indicate better and improved profitability in 2022.
Liquidity and solvency
An organisation may have a good record of operating efficiency and profitability, but it could fail because its activities are financed inappropriately. Thus, the discussion that follows considers the ratios that assess the availability of finance for an organisation’s activities in the short term, known as ‘liquidity ratios’, and those that assess its solidity from the financial point of view over the longer term, known as ‘solvency ratios’.