Limitations of Return on Capital Employed – There are several metrics for calculating a firm’s profitability and several investors prefer to return on capital employed (ROCE), a profitability ratio which could be a perfect tool for finding businesses that could provide a high return on the funds they invested into their firm.
You’ll require two main pieces of data to measure ROCE: earnings before interest and tax (EBIT) and capital employed. EBIT is a formula that takes revenue and subtracts expenses (like interest and tax). The method of calculating EBIT is as follows.
Return on Capital Employed = Earnings Before Interest and Taxes (EBIT) / Total Capital Employed X 100
Must read – How to calculate return on capital employed?
Return on Capital Employed, like many other financial ratios, has certain drawbacks.
- One of ROCE’s main drawbacks would be that, while it is very helpful when analyzing the financial performances of two firms in the same sector, it does not offer precise data while evaluating firms in separate industries
- Using ROCE as a single metric of success is ineffective because it only provides information about the firm’s capital use. As a result, it is often best to combine the ROCE ratio with many other financial ratios in order to make more wise investment choices.
- Businesses with unused cash balances would have a weaker ROCE, that will have an effect on the final outcome and the ultimate judgment. ROCE is not really the right metric for businesses with sizable, unused cash reserves.
- ROCE cannot be stable over time and can vary from year to year, based on the firm’s annual business results. As a result, while evaluating various firms, it is essential to understand ROCE patterns over time.
The Return on Capital Employed Ratio equation renders things simpler to find firms that use their capital effectively. It may be helpful for an individual looking to invest in a certain sector and compare the best performers in that sector. ROCE has been shown to be exceptionally useful in evaluating firms in extremely capital-intensive sectors.
ROCE, on the other hand, cannot be the only deciding factor. It has some drawbacks, and, like most accounting ratios, ROCE cannot offer an accurate image of a firm’s earnings stability on its own.