Profitability ratios assess how efficiently a business converts its resources into profit, helping stakeholders evaluate financial performance and investment potential.
What Are Profitability Ratios?
Profitability ratios are a key category of financial performance metrics used to evaluate how well a business generates profit in relation to its revenue, assets, equity, or capital employed. They help stakeholders—such as managers, investors, and creditors—understand how efficiently a business is running and how effective it is at turning resources into earnings.
In the AQA A-Level Business syllabus, the primary profitability ratio students are required to study is Return on Capital Employed (ROCE). This ratio is essential because it gives a broader measure of profitability by linking operating profit with the capital a business uses.
Why Are Profitability Ratios Important?
Profitability ratios are central to evaluating a business's financial health. They allow businesses and external parties to:
Assess efficiency: Determine whether the business is using its assets and investments effectively.
Compare performance: Analyse results over time or against competitors.
Inform decisions: Guide investment, lending, and operational decisions based on financial performance.
Profitability ratios help answer critical questions like:
Is the business generating enough return on its investments?
Are resources being allocated efficiently?
Is the current strategy sustainable in the long run?
Return on Capital Employed (ROCE)
Definition
Return on Capital Employed (ROCE) is a widely used profitability ratio that measures the efficiency with which a business uses its capital to generate operating profit. It shows the percentage return that a company earns on the capital employed in the business.
ROCE is particularly valuable because it takes into account both debt and equity, providing a holistic view of how all long-term funding sources are being used to drive profitability. This is especially important in capital-intensive industries, where large investments are common.
ROCE Formula
The formula to calculate ROCE is:
ROCE = (Operating Profit ÷ Capital Employed) × 100
Operating Profit is also known as Earnings Before Interest and Tax (EBIT). It reflects the profit a business earns from its normal operations before any financing costs (like interest) or tax expenses.
Capital Employed typically refers to the total long-term funds used by the business and can be calculated in two ways:
Capital Employed = Total Assets – Current Liabilities
Capital Employed = Equity + Non-current Liabilities
Both methods give the same result, but it's important to use consistent definitions when interpreting and comparing ROCE values.
This formula expresses the operating profit as a percentage of the capital invested in the business. The result indicates how much profit is generated for every pound of capital employed.
Worked Example
Let’s say a company reports the following financial figures:
Operating Profit: £80,000
Capital Employed: £400,000
Using the ROCE formula:
ROCE = (80,000 ÷ 400,000) × 100 = 20%
This result means the business is generating a 20% return on the capital it employs. In other words, for every £1 of capital employed, it is making £0.20 in operating profit.
This figure can then be used to evaluate how well the business is performing, either by comparing it to past performance or to similar businesses in the same industry.
Purpose of ROCE
The main purpose of ROCE is to assess how effectively a business is using its capital to generate profit. It is a useful tool for:
Internal management: Managers can identify how efficiently each division or product line is using resources.
Investors: Shareholders and potential investors use ROCE to determine whether a business provides a good return on their invested capital.
Creditors: Banks and other lenders look at ROCE to evaluate the financial health of a business and assess the risk of lending.
ROCE provides insight into both profitability and capital efficiency, making it a powerful measure for understanding financial performance.
Interpreting ROCE
High ROCE
A high ROCE indicates that the business is generating strong returns relative to the capital it uses. This suggests good management, strong financial performance, and efficient use of resources.
It may also reflect effective cost control, strong sales performance, or capital-light operations.
Low ROCE
A low ROCE may suggest underperformance. It could mean the business is struggling to turn its capital into profit or is inefficient in its use of assets.
It might also indicate high costs, low sales, or excessive capital investment that isn’t yet delivering returns.
However, ROCE should never be interpreted in isolation. Context is crucial.
Comparisons Over Time and Industry Benchmarks
ROCE becomes significantly more useful when used for comparative analysis.
1. Comparing ROCE Over Time (Trend Analysis)
Tracking ROCE across several years can identify trends:
A rising ROCE suggests improving efficiency and profitability.
A falling ROCE may point to growing inefficiencies, higher costs, or poorly performing investments.
For example, if a company’s ROCE over three years is:
Year 1: 18%
Year 2: 22%
Year 3: 25%
This upward trend indicates that the business is becoming increasingly effective at generating profit from its capital.
2. Comparing ROCE to Industry Averages
Comparing ROCE to industry benchmarks helps assess whether the business is performing well relative to its competitors.
For instance:
A ROCE of 20% in an industry where the average is 12% would indicate above-average performance.
A ROCE of 15% in an industry where competitors achieve 25% might be a sign of underperformance.
Different industries have different capital structures and profit margins, so comparisons should be made carefully.
What Is Considered a Good ROCE?
There is no fixed threshold, but general rules of thumb include:
Above 15% is typically considered strong.
10–15% may be seen as average, depending on industry conditions.
Below 10% may indicate poor performance, though this varies by sector.
Importantly, the ROCE should also be compared to the cost of capital:
If ROCE > cost of capital: The business is creating value.
If ROCE < cost of capital: The business may be destroying value.
Limitations of ROCE
While ROCE is an extremely useful ratio, it has several important limitations that must be understood when using it for decision-making.
1. Based on Historical Data
ROCE is calculated using figures from past financial statements.
These numbers may not reflect the current or future performance of the business.
If a business had an unusually high or low operating profit in one year due to one-off events (e.g. sale of assets, pandemic recovery), ROCE will be distorted.
2. Affected by Accounting Policies
Different accounting methods (e.g. depreciation policies, asset revaluations) can affect both operating profit and capital employed.
As a result, two businesses with the same economic reality may report very different ROCE figures.
3. Inconsistency in Capital Employed Definitions
There is no universally accepted definition of capital employed.
Some firms include total equity plus non-current liabilities, others subtract current liabilities from total assets.
This inconsistency makes cross-company comparisons less reliable unless definitions are standardised.
4. Ignores Qualitative Factors
ROCE does not consider important non-financial aspects such as:
Quality of management
Employee morale
Innovation and research
Customer satisfaction
A company might have a good ROCE but be facing reputational damage or a shrinking market.
5. Can Discourage Long-Term Investment
Managers focused on maintaining a high ROCE might avoid new investments that would initially lower the ratio, even if they would benefit the business in the long run.
For example, investing in new machinery may reduce ROCE in the short term due to higher capital employed, but increase efficiency and profits later.
6. Difficulties in Interpreting for Different Business Models
Asset-light companies (e.g. software firms) may naturally have high ROCEs due to low capital employed.
Asset-heavy companies (e.g. transport, manufacturing) may have lower ROCEs even if they are successful.
Therefore, comparing ROCEs between such businesses can be misleading.
The Need for Other Performance Indicators
Because of these limitations, it is crucial to use ROCE alongside other financial ratios and indicators to get a well-rounded understanding of business performance.
Complementary ratios include:
Liquidity ratios (e.g. current ratio): To assess short-term financial health.
Gearing ratio: To understand the level of financial risk from debt.
Efficiency ratios: To evaluate how well resources like stock or receivables are managed.
Profit margins: To analyse the proportion of revenue turned into profit.
Non-financial indicators: To assess brand strength, employee satisfaction, or product quality.
Key Point: Ratios like ROCE are not standalone indicators. They highlight areas for deeper analysis, but must be interpreted with context, trends, and supporting data. Over-reliance on one ratio can lead to flawed conclusions.
Recap of ROCE Essentials for A-Level Students
Formula: ROCE = (Operating Profit ÷ Capital Employed) × 100
Purpose: Measures how efficiently capital is being used to generate operating profit.
Interpretation: Higher ROCE = better use of capital, but must be compared over time and against industry norms.
Limitations: Includes historical bias, variable definitions, and lacks qualitative insight.
Best used with: Other financial and non-financial performance indicators for a complete picture.
FAQ
Operating profit is used in the ROCE formula because it reflects the profit generated purely from the business’s core operations, excluding interest and tax. This allows analysts to assess how effectively the business is using its capital to generate profit, without distortion from financial or tax strategies. Net profit can vary significantly due to financing and one-off items, making it less useful for evaluating operational efficiency. ROCE focuses on operational performance relative to long-term capital employed.
Yes, ROCE can be negative if the business has made an operating loss. This indicates that the company is not generating enough revenue to cover its operating costs, let alone provide a return on its capital employed. A negative ROCE is a serious warning sign of underperformance, inefficiency, or poor strategic choices. It may suggest that capital is being wasted or that the business model is fundamentally unviable, especially if negative ROCE persists over multiple periods.
A business can improve ROCE by increasing operating profit or reducing capital employed. Without increasing revenue, it may raise profit by cutting operational costs, streamlining processes, or improving productivity. Alternatively, it could sell underutilised assets, reduce stock levels, or delay capital expenditure to lower capital employed. These measures boost the ROCE ratio, even with stable revenue, by making the business leaner and more efficient. However, care must be taken not to damage long-term capacity or performance.
High depreciation reduces the book value of non-current assets, which in turn reduces capital employed. If operating profit remains stable, a lower capital employed figure will result in a higher ROCE. While this might appear positive, it can be misleading as the rise in ROCE may simply reflect accounting depreciation rather than real efficiency gains. This is why interpreting ROCE requires understanding the underlying asset values and accounting practices, especially in capital-intensive industries with high depreciation.
ROCE measures the return generated on all capital employed in the business, including both equity and non-current liabilities, whereas Return on Equity (ROE) only considers returns to shareholders. ROCE is more comprehensive because it evaluates how well the business is using all long-term funding sources. ROE, on the other hand, can be inflated by high levels of debt since it ignores borrowed capital. As such, ROCE is a better measure for assessing overall business efficiency and capital utilisation.
Practice Questions
Analyse how a fall in Return on Capital Employed (ROCE) might affect a business’s decision-making. (10 marks)
A fall in ROCE indicates declining efficiency in generating profit from capital employed, which could signal poor use of resources. Managers may respond by reviewing investment decisions, delaying capital expenditure, or cutting underperforming projects. Investors might become concerned about lower returns and reduce funding or sell shares. The business may also reassess cost structures to improve operating profit. Additionally, a declining ROCE compared to competitors could affect competitive positioning, prompting strategic changes. However, decision-makers must consider whether the fall is due to short-term investments that may lead to long-term gains, highlighting the importance of context in financial analysis.
Assess the usefulness of ROCE as a measure of business performance. (12 marks)
ROCE is a widely used measure of profitability and efficiency, showing how well a business uses capital to generate profit. It is especially useful for comparing performance over time or against industry benchmarks. A high ROCE generally reflects strong management and effective capital use. However, it has limitations. ROCE uses historical data and may be distorted by inconsistent definitions of capital employed or accounting methods. It also ignores qualitative factors such as leadership or brand value. Therefore, while useful, ROCE should be used alongside other financial ratios and qualitative information to make informed judgements about business performance.
