A frequently overlooked financial measurement for small and medium sized businesses is ROCE, Return on Capital Employed (easily confused with Return on Common Equity). Particularly in small- and medium-sized businesses, this measure is commonly not put in front of senior executives, who get a steady diet of detailed reporting on gross margins and net profit.

Definition

Return on Capital Employed is a measure that compares profitability against the capital it takes to generate that profit.

Calculated as:

Interpretation

Return on Capital Employed will show the amount of profit each dollar of investment generates.

As a manager, it is reasonable to compare ROCE against the interest rate to borrow money as well as the return on a relatively low risk investment (money market rate or maybe long term bonds).

If your ROCE is lower than your borrowing interest rate, it means that for each dollar of borrowing, your shareholders/owners are losing money. You would be borrowing money and earning less than the cost of borrowing.

If your ROCE is lower than an alternate investment’s rate of return (particularly one with less risk), it may be worth examining moving the investment capital away from the low ROCE business.

ROCE compared to Profit Margins

ROCE shows the effectiveness of your capital invested in your business.

Profit Margins show the amount of money left over after expenses versus the total amount of revenue. It is a ratio of how much you get to keep.

While both are certainly key metrics of business performance, in managing my own company, I look first at ROCE and then secondly to Profit Margins. Both are ratios related to profit, but if my capital is poorly deployed in a certain business and could earn more elsewhere, how much of total revenues I keep may not matter.

Real Example

As an example, I looked up public information on Coca-Cola and Pepsi today:

1. Coca-Cola (KO)
   • ROCE: 22.7
   • Net Profit: 23.6
2. Pepsico (PEP)
   • ROCE: 15.9
   • Net Profit: 12.8

Here are two companies, in the same industry, with a product that is virtually the same (although I have to admit, I’ll take a Coke over a Pepsi any day).

Coke’s performance is significantly better. “The Real Thing” generates $0.23 profit for each dollar of capital it is holding. That is sort of like a 23% interest rate on one’s investment. Sugar water generates $0.24 profit from each dollar that comes into the company. What a great business to be in! It is a money making machine.

“The Taste of the New Generation” does significantly worse, but still quite well. It generates $0.16 profit from each dollar it holds for its investors and keeps $0.13 of each dollar that comes in.

Another Example

Let’s assume two businesses, one a grocery store and the other an airline, both have a net profit margin of 1%. Both industries are high revenue, low profit businesses. Let’s say that both generated $100 million dollars in profit. As a grocery store generally requires less capital than an airline. The grocery store will have a higher ROCE and might be the better business from an owner’s perspective.

Photo Credit: Jofre Ferrer

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