Return on Capital Employed (ROCE) is a valuable profitability ratio, but it comes with several notable disadvantages that can limit its effectiveness as a standalone metric for financial analysis. Key drawbacks include its short-term focus, inability to account for varying risk levels, vulnerability to accounting manipulations, and challenges in cross-industry comparisons.
Understanding Return on Capital Employed (ROCE)
Before diving into its limitations, it's helpful to briefly understand ROCE. ROCE measures how efficiently a company uses its capital to generate profits. It is calculated as:
$$
\text{ROCE} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Capital Employed}}
$$
Where Capital Employed is typically total assets minus current liabilities, or shareholders' equity plus non-current liabilities. A higher ROCE generally indicates better performance, but this ratio, like any other, has its blind spots.
Key Disadvantages of Return on Capital Employed
While informative, ROCE presents several challenges that analysts and investors should be aware of:
1. Short-Term Focus Over Long-Term Vision
One significant drawback of ROCE is its tendency to focus on achievements that happen in the short-term. This means it may not be a good measure of more longer-term successes a company may experience. Managers might prioritize projects that offer immediate returns to boost the current ROCE, potentially at the expense of strategic, long-term investments that could offer greater value over time, such as research and development or significant infrastructure upgrades. This can lead to underinvestment in future growth.
2. Inability to Account for Risk
ROCE provides a single percentage without differentiating between the risk profiles of various investments. ROCE cannot be adjusted to account for different risk factors from different investments a company has made. A company might achieve a high ROCE by undertaking very risky projects, while another with a lower ROCE might be generating profits from stable, low-risk ventures. Without considering the underlying risk, ROCE can present a misleading picture of a company's financial health and sustainability.
3. Vulnerability to Asset Valuation Distortions
The "Capital Employed" component can be problematic. It often relies on historical asset costs, which may not reflect current market values.
- Older Assets: Companies with older, fully depreciated assets may show an artificially high ROCE because their capital employed base is low, even if their assets are less efficient.
- Revaluation Policies: Different accounting policies for asset revaluation can lead to inconsistencies, making comparisons between companies difficult.
- Intangible Assets: The treatment of intangible assets (like brands or patents) can also vary, impacting the capital employed calculation.
4. Susceptibility to Manipulation
Companies can employ various strategies to artificially inflate their ROCE, making it less reliable for discerning true operational efficiency.
- Asset Disposals: Selling off underperforming or non-essential assets can reduce the "Capital Employed" denominator, thereby boosting the ROCE without necessarily improving operational profitability.
- Underinvestment: Delaying necessary capital expenditures or maintenance can temporarily reduce capital employed and increase short-term profits, but at the cost of long-term asset health and competitiveness.
- Delaying Working Capital Investments: Reducing inventory levels or delaying payments to suppliers can temporarily improve working capital, impacting the capital employed figure.
5. Challenges in Cross-Industry Comparisons
ROCE is highly dependent on a company's capital intensity, which varies significantly across different sectors.
- Capital-Intensive Industries: Industries like manufacturing, utilities, or telecommunications typically require massive investments in property, plant, and equipment, resulting in a large "Capital Employed" figure and often lower ROCE.
- Service-Based Industries: Companies in service sectors, which have fewer physical assets, may show a higher ROCE even if their absolute profit generation is lower.
This makes direct comparisons of ROCE between, for example, a software company and an airline, largely meaningless.
6. Ignores the Cost of Capital
While ROCE uses capital, it doesn't explicitly compare the returns generated against the actual cost of acquiring that capital (e.g., interest on debt, required return on equity). A company might have a positive ROCE, but if its weighted average cost of capital (WACC) is higher than its ROCE, it's effectively destroying shareholder value. Metrics like Economic Value Added (EVA) address this by comparing returns against the cost of capital.
7. Can Discourage Long-Term Investment
Managers under pressure to maintain a high ROCE might shy away from investing in new projects, even if they are strategically sound, if those projects initially dilute the ratio. New investments often require significant capital outlay before they start generating substantial returns, thus temporarily lowering ROCE. This can stifle innovation and growth.
Summary of ROCE Disadvantages
| Disadvantage | Explanation |
|---|---|
| Short-Term Focus | Prioritizes immediate returns, potentially neglecting long-term strategic investments and growth. |
| Ignores Risk | Does not differentiate between low-risk and high-risk investments, providing an incomplete picture of performance quality. |
| Asset Valuation Issues | Capital employed based on historical costs can distort the ratio, especially with older assets or varying depreciation policies. |
| Susceptible to Manipulation | Can be artificially inflated by selling assets, delaying investments, or manipulating working capital. |
| Difficult Cross-Industry Comparison | Capital intensity varies widely across industries, making ROCE comparisons between different sectors misleading. |
| Neglects Cost of Capital | Does not factor in the actual cost of financing the capital employed, potentially overlooking value destruction. |
| Discourages Long-Term Investment | Managers might avoid new, strategically beneficial projects if they initially dilute the ROCE ratio, hindering innovation and future growth. |
Mitigating ROCE's Limitations
To get a more comprehensive view of a company's financial health and operational efficiency, it's crucial to use ROCE in conjunction with other financial metrics and qualitative analysis.
- Complement with Long-Term Metrics: Pair ROCE with metrics like Free Cash Flow (FCF), Return on Invested Capital (ROIC) (which often uses a market value basis for capital), or Economic Value Added (EVA) to assess long-term value creation and compare against the cost of capital.
- Consider Risk Factors: Always evaluate ROCE in the context of the company's industry, business model, and the specific risks associated with its operations and investments.
- Analyze Trends: Instead of focusing on a single year's ROCE, analyze its trend over several years to identify consistent performance or potential manipulation.
- Industry Benchmarking: Compare ROCE with competitors within the same industry, ideally those with similar business models and asset bases.
- Review Capital Expenditure (CapEx): Examine a company's CapEx plans to understand if it's investing for future growth or merely cutting back to boost short-term ROCE.
- Look at Asset Turnover and Profit Margins: Deconstruct ROCE into its components (EBIT margin and capital turnover) to understand whether profitability is driven by high margins or efficient asset utilization. Learn more about financial ratio analysis from sources like Investopedia.
By understanding and addressing these limitations, investors and analysts can use ROCE more effectively as part of a broader financial assessment.
