Last Updated on Oct 7, 2022 by Anjali Chourasiya
There are various financial metrics to analyse a company. Out of all, Return on Equity (ROE) and Return on Capital Employed (ROCE) are used to measure a company’s operational efficiency and potential for attaining future growth. However, they are often confused with each other, whereas in reality, they are quite different. In this article, let’s look at ROE and ROCE in detail and ROE Vs ROCE.
Table of Contents
In simple terms, ROE shows how much return shareholders are earning for every rupee they have invested in a company. It indicates the financial health, efficiency, and profitability of a company. Fundamental investors often use ROE to make investment decisions.
ROE is calculated as:
ROE formula = Net income / Shareholders’ equity
The net income can be derived from the income statement and is the profit generated by the company before paying the dividend to its shareholders. Whereas shareholders’ equity can be found in the balance sheet and is the difference between a company’s assets minus its liabilities.
A higher ROE represents higher profits earned on equity and efficient company management. However, a very high ROE shows that the funds are lying idle with the company. Hence, relying only on ROE for the analysis of a company is not a better idea.
To measure a company’s performance using ROE, it is important to compare the ROE of a company to the industry average but also to similar companies within the same industry.
ROCE is a financial ratio used to assess the company’s efficiency in generating profits as a percentage of the total capital used by the company. It tells the investors and managers how efficiently the company uses its capital.
ROCE is calculated as follows:
Return on capital employed = Earnings Before Interest and Tax (EBIT) / Capital employed
EBIT is the operating income from the regular activities of the business, and capital employed refers to the amount invested in a business.
The higher the value of the ROCE ratio, the better the chances of profits. It also implies that the capital employment strategies of a company are more efficient. The ROCE of a company can also be viewed in relation to that of its historical periods to assess the consistency at which capital is efficiently employed.
ROE Vs ROCE
Investors often confuse ROE and ROCE with each other. However, they are different from each other. Here are five differences between ROE and ROCE.
|Definition||It is the percentage of a company’s net income that is returned to shareholders as value.||It measures how efficiently a company can generate profits from its capital employed.|
|Capital||It considers only the shareholder capital employed.||It considers the total capital employed including debt by the company.|
|Indicator of||Effective management of equity financing to fund operations||Efficient utilisation of total capital|
|Scope||It is limited as only one factor (equity) is considered.||It offers a wide scope as it comprises both debt and equity.|
|Applicability||It, more or less, can be used to study all companies and their returns.||It works better for capital-extensive industries.|
|Stakeholder significance||It is of more significance to the shareholders as it shows them the returns the company provides for every rupee they invest. It also shows them what is left for them after the debt is serviced.||It is of significance to both the shareholders and the lenders as it shows the effectiveness of the total capital employed in the capital.|
|Income consideration||The income considered here is the profit after all the interest and taxes are charged.||The income considered here is the earnings before taxes and interests are charged.|
Combined analysis of ROE and ROCE
Both ROE and ROCE are useful for evaluating a company’s overall performance. When ROCE exceeds ROE, it indicates that the company has effectively used debt to lower its overall cost of capital. However, the higher ROCE shows that the company is generating higher returns for the debt holders than for the equity holders. This might not be good news for stockholders.
ROE and ROCE provide a comprehensive picture of the financial performance of the company. Hence, when analysing a company, consider both the factors, ROE and ROCE. To know about a company’s ROE and ROCE, check their stock pages at Tickertape. You can also list companies based on these parameters using the Tickertape Stock Screener. Explore now!
1. Which is better – ROE or ROCE?
While ROE considers overall accounting profits in relation to shareholders’ funds, ROCE uses a superior measure due to its focus on overall assets and operating profits. Both play important roles in analysing a company’s financial performance
2. Can ROE be greater than ROCE?
While ROCE is often higher than ROE, the situation can sometimes be reversed. ROE can be greater than ROCE when there is higher growth in net income. The higher the ROE, the better a company is at converting its equity financing into profits.
Hence, when the revenue is growing, and the company is highly leveraged, the ROE will be greater than ROCE due to fixed interest rates and tax benefits on interest payments.