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Profitability ratios are financial metrics that are used by various stakeholders and investors while investing in a company. ROE and ROCE are profitability ratios often used together to evaluate the complete financial performance of a company. The return on equity signifies the company's ability to generate returns on the investment made by its shareholders(equity). On the other hand, the return on capital employed reflects the company's capital efficiency and profitability.Let’s look at each one of them in detail :
ROE (Return on Equity)
The return on equity measures the rate of return received by the company's shareholders on their investment. It is more significant for investors since it helps them to judge how efficiently the company is utilizing their invested money. The higher the ratio, the better is the performance of the company. The formula used to calculate ROE is:
| ROE = Net Income / Shareholder’s equity. |
The Net income here is the profit generated by the company before paying the dividend to its shareholders. It appears as a part of the Income Statement, and the net income generated for the past 12 months is generally used for ROE calculation.The shareholder’s equity is the difference between a company’s assets minus its liabilities. It shows what will be left with the company for its investors if the company settles all its liabilities with the available assets.
ROCE (Return on Capital Employed)
ROCE measures the return on capital employed to reflect upon how efficiently the company is utilizing its capital to generate profits. It is an important measure for investors that gives them an insight into the company’s capabilities before making an investment decision. The formula used to calculate ROCE is:
| ROCE = EBIT / Capital Employed. |
Here, EBIT is the earnings of the company before interest and tax payments have been made. The capital employed is total assets minus current liabilities which is equivalent to shareholder’s equity plus long-term debts of the company.The higher the value of the ROCE ratio, the better are the chances of profits. The investors must look for companies with higher ROCE value and compare it with the various other companies, before arriving at an investment decision.
| As suggested by Warren Buffet, you must prefer companies that have ROE and ROCE above 20% and both the values should be close to each other. |
ROE Vs ROCE:
| ROE (Return on Equity) | ROCE (Return on capital Employment) |
| The objective of ROE is to assess how efficiently the equities are used and managed by the company. | The objective of ROCE is to reflect upon how efficiently the employed capital is being used and managed by the company. |
| It is a significant ratio from the investor’s point of view since it focuses on equity. | It is a significant ratio from the company’s perspective since it focuses on the total capital employed(Debt+Equity) |
| It uses Net Profit(or Profits After Tax) for ROE calculation. | It uses operating profits or EBIT(earnings before interest and tax) for ROCE calculation. |
| It gauges the profitability for equity shareholders. | It gauges the profitability for all the stakeholders(equity and debt). |
Combined Analysis of ROE and ROCE:
It is suggested to use both ROE and ROCE together for evaluating the overall performance of a company. If the ROCE value is higher than the ROE value, it implies that the company is efficiently using its debts to reduce the cost of capital. A higher ROCE indicates that the company is generating higher returns for the debt holders than for the equity holders. Hence, together they provide you with a better picture of the financial performance of the company.
DISCLAIMER
The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.
