The terms ROE and ROCE are often used interchangeably and may seem confusing to new investors. Although they are both significant financial ratios, Return on Equity (ROE) and Return on Capital Employed (ROCE) measure different things. While ROE shows how well a business uses the equity held by shareholders to create profit, ROCE shows how well a business uses all of its capital sources, including debt.
This article will decode these frequently used metrics for business performance. We will cover their definitions, formulas, distinct usages, and which one you should look at.
What Is ROE?
ROE is a financial ratio that’s used to evaluate how successful an organisation is at using the equity of its shareholders to generate profits. It is a crucial metric for equity investors that indicates the company’s capacity to generate returns on investment and optimal return on equity. A high ROE is a sign that a company’s management is effective at using equity financing to drive revenue and expansion. In general, investors view a ROE of 15% to 20% as optimal, and anything higher as good. However, it is important to note that the optimal ROE value can vary from industry to industry.
What Is the ROE Formula?
ROE = Net Income / Shareholders’ Equity
Where,
Net Income = Total Revenue – Total Expenses
Shareholders’ Equity = Total Assets – Total Liabilities
What Is the Importance of ROE?
ROE allows a company to assess how well it is using its equity and allows investors to determine whether they are receiving a good return on their investment. ROE won’t help you if it is only considered in isolation; it must be compared to the company’s historical ROE as well as the average ROE for the industry. To obtain a more thorough and knowledgeable image of the business for assessment purposes, one can examine additional financial ratios. A business is more likely to fail due to debt if it has a high ROE and a low ROCE. On the other hand, a business that has a high ROCE and a low ROE suggests that equity investors should not invest in it.
What Is ROCE?
ROCE can be used to evaluate the profitability and capital efficiency of a business. This ratio can be used to determine how well a business is using its capital to generate profits. When evaluating a company for investment, financial managers, stakeholders, and possible investors may employ a number of profitability ratios, including ROCE. It can give them a clear picture of a company’s financial health when used with other financial ratios like ROE.
What Is the ROCE Formula?
Why Is ROCE Important?
The percentage of profit a company makes on its capital employed, or return on capital employed, is indicated by its ROCE. When considering both debt and equity, ROCE provides a more accurate picture of a business’s total efficiency in turning a profit from all of its capital. It is especially helpful for comparing businesses. Within an organisation, ROCE is a helpful management tool for evaluating the performance of various projects or business units.
Major Differences Between ROE vs ROCE
| Feature | ROE |
ROCE |
|
Indicates |
How effectively equity capital is being used | How efficiently the company utilises its capital |
|
Formula |
Net Profit / Shareholders’ Equity | EBIT / Total Capital Employed |
|
Considers |
Net Profit or PAT (Profit After Tax) | Operating Profit or EBIT (Earning Before Interest & Taxes) |
| Low/High-Value Meaning | A high ROE shows equity shareholders are profitable. In this case, if the ROCE is low, the company is under severe debt. This can later hamper its growth and equities. | A high ROCE denotes the company and debt shareholders are in profits. In this case, if the ROE is low, it indicates that the company’s equity investments are not paying off. |
Which Is More Preferable, ROCE or ROE?
You might be wondering which is better to use when evaluating a company now that you’ve seen the comparison between them.
While lenders or bond investors find it more sensible to consider ROCE, both ROE and ROCE are important from the perspective of a share investor.
When a company goes bankrupt or decides to shut shop, it first pays off its debtors. An investor should know how much the company profits from its debt and equity. This helps them understand the following:
- What are the chances of the company sustaining the business?
- How likely are they to get paid when the chances are NIL.
ROCE gives an overview of the overall profitability of a company. Later, the company will also use the profits to further expand its business. Investors must be familiar with ROCE when investing.
A high ROE with a low ROCE denotes that a company is likely to succumb to debt. Conversely, a company with a low ROE and a high ROCE indicates that it has no value for equity investors. As an investor, it is better to go for companies where the ROE and ROCE are not dramatically contrasting.
Are ROCE and ROE Enough to Assess a Company’s Financial Health?
Financial ratios like ROCE and ROE are significant. They gauge various facets of a business’s financial performance. However, to get a comprehensive view of a business’s financial performance, it is important to combine the 2 ratios with other metrics such as current ratio, quick ratio, and debt-to-equity ratio.
Conclusion
ROE and ROCE are both crucial financial ratios, measuring the equity capital performances and the usage of capital for the company’s financial health. If ROCE and ROE have drastically different figures, one should look at the reasons causing the difference. If the ROCE is high it could be because the equity capital isn’t being properly utilised, however, the company can run profitably. If the ROE is high, the debt assets could be weighing over the equity ones. A look at the other parameters including PAT, Earnings per Share, Operational Capital, etc. would reveal the real picture behind the imbalance.
Looking to enter the trading world? With TradeSmart, you can trade with a brokerage rate as low as ₹15 and open a FREE demat account. With more than 20 years of experience in the NSE and BSE stock markets, we are well-equipped to provide you with real-time assistance during business hours.
FAQs
What is the significance of ROE?
ROE demonstrates the efficient use of equity capital and caters exclusively to the needs of stock investors. ROE provides a more accurate indicator of a business’s profitability from shareholders’ equity.
What is the significance of ROCE?
ROCE demonstrates how well the business uses its capital. ROCE is more useful for company investors as it considers both debt and equity for profitability.
What are some of the drawbacks of ROE?
ROE doesn’t factor in intangible assets of a company such as its patents or goodwill that can have a long-lasting effect on the market. In the case of share buybacks, the ROE shoots up, which isn’t a realistic measure of the company’s risk in business.
What are some of the drawbacks of ROCE?
ROCE factors in the EBIT, and not the real profit, which can often be misleading if the company operates in a high-tax-paying industry. The ROCE alone can’t help us understand whether the debt assets and the equity assets are separately justified or not.
Should I look at ROCE or ROE?
When assessing a company’s financial performance, ROCE and ROE should be combined. A business that generates high returns on both equity and capital employed and has both a high ROE and ROCE is regarded as a good investment if other metrics are satisfactory. It is important to note that both these measures vary by industry, and should be combined with other metrics for a more comprehensive picture.
