Thread by @money_theory

Return on capital employed (ROCE):

ROCE is one of the most important financial ratios out there.

Today I will try to explain it in a simple way. Grab a bar of dairy milk silk and let's get started.

Say, after witnessing the recent rally in Indian pharma stocks, you decided to start a pharmacy business.

And it required a capital of 10 lakhs. You poured in your own funds of 4 lakhs and borrowed 6 lakhs from the bank and started the business.

The business sales were 20 lakhs and you made an operating profit of 2 lakhs for the year.

Now you want to know how much returns your business has actually made.

After thinking for a while, you have understood that profits divided by capital should give you the return on capital.

You have done the math and came up with a return on capital of 20% on your business.

And Boom there you go.

ROCE tells you how well a business is generating profits on capital employed.

The formula is ROCE = EBIT/Capital employed

Whereas

EBIT = Earnings before Interest & taxes

Capital employed = Equity + Debt

From looking at the above example, you can observe that

EBIT = Profits = 2 lakhs

Equity = Own funds = 4 lakhs

Debt = Bank funds = 6 lakhs

You got a return on capital of 20%

But stop not, there is more to dive in.

Let's break the formula further.
You can rewrite the formula like this

ROCE = (EBIT/Sales) * (Sales/Capital)

Sales can be cancelled on both numerator and denominator sides. So you can't blame me for that.

Now, comes the interesting part. You can further write this as below

ROCE = EBIT margin * capital turnover

Let's take a moment to acknowledge and understand these two new guests that have appeared.

EBIT margin:

It is pretty simple. It tells your business profit margin.

The formula is EBIT/Sales

You have earned 2 lakhs on a sales amount of 20 lakhs bringing your EBIT margin to 10%

Capital turnover:

This one measures the efficiency of a business's use of capital in generating sales

The formula is Sales/Capital

So with a capital of 10 lakhs, you generated revenue of 20 lakhs bringing the ratio to 2 times.

The higher the ratio, the better the efficiency

By substituting these two in the new formula,

You would get the same return on capital of 20% (10% margin * 2 times )

Generally speaking, look for companies that generate a return on capital above 15% and also which is stable and growing.

To conclude, Return on capital depends upon the operational efficiency and capital efficiency of a business.

That's it, folks. Hope you enjoyed reading. Like and retweet if you find the thread value-added. Have a great day.