So often we read or hear in the media about the latest fast-growing business. Everyone seems to focus on the growth of the business but what is the real measure of business success? One of the key measures that accountants and business consultants look for when reviewing the financial performance of a business, is Return on Capital Employed (ROCE). Generally, if this rate of return isn’t high enough it is usually a sign that some things aren’t quite right in the business. But what is ROCE, how is it calculated and what levers can you pull to help improve it?
ROCE is a key performance measure because it focuses on the relationship between the inputs and outputs of the business. In accounting speak; the inputs of a business are included in the balance sheet – things like stock, debtors, creditors, plant & equipment etc. The outputs are included in the profit and loss statement – things like sales, cost of sales (or margin), expenses etc.
What is ROCE (Return on Capital Employed)?
Return on Capital Employed (ROCE) is a key financial metric that measures how efficiently a business is using its capital to generate profits. It helps business owners assess their company’s financial health and performance, making it a crucial indicator for investors and stakeholders.
How is ROCE Calculated?
ROCE is calculated using the following formula:
Where:
- Earnings Before Interest and Tax (EBIT) represents the company’s operating profit before interest and taxes.
- Capital Employed is the total assets of the business minus current liabilities (or total equity + non-current liabilities).
A higher ROCE percentage indicates better capital efficiency and profitability. Now, let’s explore seven effective ways to improve your business’s ROCE.
So How Can You Boost Your ROCE?
Improving your ROCE (Return on Capital Employed) is essential for long-term business success. By optimising costs, increasing revenue, managing assets efficiently, and making strategic financial decisions, you can significantly enhance profitability.
1. Optimise Operating Costs
Reducing unnecessary expenses and improving cost efficiency can significantly boost ROCE. Consider:
- Negotiating better supplier contracts to lower procurement costs.
- Automating repetitive tasks to reduce labour expenses.
- Reviewing utility costs and switching to cost-effective alternatives.
By cutting operational waste, you improve profit margins, enhancing the return on capital employed. Look at the percentage that your pre-tax profit bears to your sales. Ideally, you should be looking at EBIT or earnings (profit) before interest and tax. The higher this percentage the better, but as a guide a profitability percentage of less than 5% is too low.
Generally, you’ll find that focusing on margin will yield the biggest ‘bang for buck’ in lifting profitability, but sometimes we let expenses get out of hand.
2. Increase Sales Revenue
Higher revenue leads to a stronger ROCE. Strategies to increase sales include:
- Expanding into new markets or launching new products/services.
- Enhancing customer retention through loyalty programmes.
- Upselling and cross-selling to existing clients.
Driving revenue growth while keeping costs controlled will boost capital efficiency. One of the key influencers of your profitability percentage is your gross profit margin. If your profitability percentage is too low then the chances are you’re not making enough margin on your sales. Some businesses reduce margin in order to generate additional sales. Depending on the stage of the business cycle you’re in, this can be a road to destruction.
For small (or micro) businesses, scale can be a problem. This is because you’ve got fixed costs just to open your doors. That means that until you reach a critical mass, you’re likely to run at a loss. But don’t chase volume (or sales) for the sake of it. At the end of the day, you need to make a profit on what you sell. Once you reach your ‘break even’ point you should focus on building margin, so that you make more profit.
3. Improve Asset Utilisation
Efficient asset management can enhance return on capital employed. To achieve this:
- Eliminate underperforming assets that are not contributing to profitability.
- Lease rather than buy capital-intensive equipment to maintain flexibility.
- Improve production efficiency to reduce downtime and increase output.
Maximising asset productivity ensures that every dollar of capital contributes to business growth.
Sometimes business accumulate unnecessary assets that are no longer needed. This represents real cash which can be freed up by offloading these assets. Businesses can sometimes have a “lazy” balance sheet. This means that may have excess plant and equipment, excess stock holdings or debtor management has deteriorated. Cleaning up a “lazy” balance sheet is essential for good business performance.
4. Reduce Debt Levels
Excessive debt increases financial risk and impacts ROCE negatively. Lower debt by:
- Refinancing existing loans at lower interest rates.
- Using retained earnings for reinvestment rather than excessive borrowing.
- Strengthening cash flow management to minimise reliance on external funding.
A lower debt burden improves capital efficiency and profitability.
5. Enhance Working Capital Management
Efficient working capital management can improve ROCE by optimising cash flow. Key areas to focus on:
- Shortening debtor collection periods to accelerate cash inflows.
- Negotiating longer payment terms with suppliers to preserve liquidity.
- Managing inventory effectively to prevent overstocking or understocking.
Keeping working capital lean ensures more capital is available for high-return investments.
6. Invest in High-Return Projects
Not all investments generate the same returns. To improve return on capital employed, prioritise projects that:
- Deliver strong, long-term profitability.
- Align with your core business strengths.
- Offer a competitive advantage in the market.
By investing wisely, you ensure capital is employed in the most profitable areas of your business.
7. Continuously Monitor and Adjust Strategy
Regularly reviewing your ROCE ensures that you stay on track towards financial efficiency. Best practices include:
- Conducting regular financial analysis to track trends.
- Benchmarking against industry standards to identify improvement areas.
- Seeking expert financial advice to refine your business strategy.
A proactive approach to financial management helps maintain a strong return on capital employed over time.
At the end of the day, ROCE drives business value. If you want to increase the value of your business then focus on increasing your ROCE. Business benchmarking is a great way to see how you compare to other businesses in your sector or industry. And working with a business coach can help you get some external perspective and identify the low hanging fruit to improve your profitability.
Give the business growth team at MGI a call and let us help you improve your ROCE.