Return on capital employed (ROCE)

6.1 Return on Capital Employed (ROCE)

Definition (syllabus wording)

Return on Capital Employed (ROCE) is a profitability ratio that shows the percentage return earned on the total capital that a business uses to generate its operating profit. It measures how efficiently the capital employed in the business is being used.

Formula

• Exam‑friendly plain‑text version: ROCE = (Operating profit ÷ Capital employed) × 100
• LaTeX version (for digital notes): $$\text{ROCE}= \frac{\text{Operating profit}}{\text{Capital employed}}\times 100\%$$

Components

Operating profit

• Profit before interest and tax (EBIT). It reflects profit generated from the core business activities and excludes financing costs and tax.

Capital employed (syllabus‑required methods)

Capital employed can be calculated in either of the two ways listed in the Cambridge IGCSE syllabus:

1. Equity + Non‑current liabilities
2. Total assets – Current liabilities

Both give the same result. A third, equivalent method – Fixed assets + Working capital – is sometimes shown in textbooks but is not required for the exam.

Working capital = Current assets – Current liabilities

Step‑by‑step calculation

1. Extract the operating profit (EBIT) from the profit and loss account.
2. Calculate capital employed using one of the syllabus methods.
3. Insert the figures into the ROCE formula.
4. Multiply by 100 and round the final answer to one decimal place (unless the question states otherwise). Do not round intermediate figures.

Rounding note (exam tip)

For IGCSE/AS‑Level exams the usual convention is to present ROCE to one decimal place (e.g., 32.4 %). Keep full figures until the last step to avoid rounding errors.

Example calculation

Extracts from the financial statements of XYZ Ltd for the year ended 31 December 2024:

Step 1 – Capital employed (method 2)

Total assets = Fixed assets + Current assets = 300,000 + 150,000 = 450,000

Capital employed = Total assets – Current liabilities = 450,000 – 80,000 = 370,000

Step 2 – ROCE

ROCE = (120,000 ÷ 370,000) × 100 = 0.3243 × 100 = 32.4 % (rounded to one decimal place)

Interpretation – four points required by the syllabus

• Performance indicator: A high ROCE shows that the business is generating a strong return from the capital it employs.
• Comparison with cost of capital: If ROCE > the company’s average cost of capital (e.g., interest rate on loans), the business creates value for shareholders.
• Trend analysis: An increasing ROCE over several periods suggests improving efficiency; a falling ROCE may indicate over‑investment, declining profitability, or asset ageing.
• Inter‑firm comparison: ROCE enables comparison with competitors or industry averages, helping investors decide where to allocate capital.

Use of ROCE by interested parties

• Owners / shareholders: Assess whether the business is delivering a satisfactory return on the capital they have invested.
• Managers: Evaluate the efficiency of capital utilisation and guide decisions on asset acquisition or disposal.
• Creditors (banks, suppliers): Gauge the company’s ability to generate returns that can service debt and meet interest obligations.
• Potential investors: Compare ROCE with other investment opportunities to judge relative profitability.

Limitations of ROCE (specific to the ratio)

• Ignores non‑operating assets such as investments that may also generate returns.
• Can be distorted by accounting policies – e.g., different depreciation methods change operating profit and the net book value of fixed assets.
• Does not reflect the risk profile of the capital employed (e.g., high‑risk projects may have a high ROCE but also high volatility).

General limitations of ratio analysis (syllabus point 6.5)

• Financial statements are prepared on a historical‑cost basis; current market values are not shown.
• Ratios are based on accounting figures, which can be influenced by policy choices (valuation, matching, conservatism).
• Ratios do not consider qualitative factors such as market conditions, management quality, or technological change.

Effect of accounting principles on ROCE

• Matching principle: The way expenses (e.g., depreciation) are matched to revenue affects operating profit.
• Valuation principle: Revaluation of assets or different depreciation rates alter the net book value of fixed assets, thus changing capital employed.

Quick‑reference summary of the eight IGCSE ratios (Section 6)

Typical exam tasks (ROCE)

1. Calculate ROCE using figures supplied in a profit and loss account and balance sheet.
2. Explain why ROCE is a more appropriate measure of performance than a simple profit margin for a capital‑intensive business.
3. Analyse a three‑year trend in ROCE and suggest possible reasons for any increase or decrease (e.g., changes in profit, asset purchases, financing decisions).
4. Discuss how different interested parties would use the ROCE figure.

Checklist – syllabus points covered (AO1, AO2, AO3)

• AO1 – Define ROCE and state the two syllabus‑required ways of calculating capital employed.
• AO1 – List the four interpretation points required by the syllabus.
• AO1 – Identify the interested parties who use ROCE and why.
• AO2 – Perform a full ROCE calculation (including rounding to one decimal place).
• AO2 – Show the effect of a change in operating profit or capital employed on the ratio.
• AO3 – Evaluate the usefulness of ROCE, referring to its limitations and to the broader limitations of ratio analysis.
• AO3 – Compare ROCE with another ratio (e.g., profit margin) to justify its relevance for a capital‑intensive firm.

Suggested flow‑chart (description for notebook)

1. Start → Extract Operating profit (EBIT) from P&L.
2. Calculate Capital employed (choose: Equity + Non‑current liabilities OR Total assets – Current liabilities).
3. Apply ROCE formula.
4. Round to one decimal place.
5. Interpret → performance, cost of capital, trend, inter‑firm comparison.
6. End.