FORMULA:

It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed.It is computed as followed:

ROCE =Profit before interest and taxation/Total assets less current liabilities

Capital = Shareholders' equity plus non-current liabilities employed (or total assets less current liabilities) The underlying principle is that we must compare like with like, and so if capital means share capital and reserves plus non-current liabilities and debt capital, profit must mean the profit earned by all this capital together. This is PBIT, since interest is the return for loan capital.

What does a company's ROCE tell us? What should we be looking for? There are three comparisons that can be made:

(a) The change in ROCE from one year to the next can be examined. (b) The ROCE being earned by other companies, if this information is available, can be compared with the ROCE of one's company. (c) A comparison of the ROCE with current market borrowing rates may be made: (i) What would be the cost of extra borrowing to the company if it needed more loans, and is it earning a ROCE that suggests it could make profits to make such borrowing worthwhile? (ii) Is the company making a ROCE which suggests that it is getting value for money from its current borrowing? (iii) Companies are in a risk business and commercial borrowing rates are a good independent yardstick against which company performance can be judged.