Difference Between ROCE and ROE
If you are an investor wanting to assess a company's profitability, understanding Return on Capital Employed (ROCE) and Return on Equity (ROE) is key.
ROCE evaluates how effectively a company uses all its capital to generate profits, while ROE shows the profit made solely for shareholders.
This blog explores the difference between ROE and ROCE, explaining how they measure profitability, their distinctions, and more.
What is ROE in the Share Market
Return on Equity (ROE) indicates the return you earn for each rupee you invest in a company. It reflects the company's financial health, efficiency, and profitability.
You can calculate ROE using the following formula:
|
ROE = Net Income/Shareholders’ Equity |
Net income represents the profit a company makes before paying dividends to shareholders, and shareholders' equity is the difference between the company's assets and liabilities.
A higher ROE indicates that the company is earning more profit from its equity and is managing its resources well. However, an extremely high ROE might suggest that the company is not using its funds effectively. Therefore, relying solely on ROE to evaluate a company's performance is not advisable.
What is ROCE in the Share Market
Return on Capital Employed (ROCE) is a financial ratio used to evaluate a company's profitability and how efficiently it uses its capital.
This ratio is particularly useful for comparing companies in capital-intensive industries such as oil and gas, telecommunications, and iron and steel.
ROCE is calculated using the following formula:
|
ROCE = Earnings Before Interest and Taxes (EBIT)/Capital Employed |
EBIT represents the operating income from the company's regular activities, while capital employed refers to the total amount invested in the business.
A high ROCE suggests that a significant portion of the company's profits can be reinvested for the benefit of shareholders, indicating efficient use of capital. This means the company can reinvest its capital at a higher rate of return.
Difference Between ROE and ROCE
The following table highlights the difference between ROE and ROCE:
|
Parameters |
ROE |
ROCE |
|
Objective |
Examines a company's effectiveness in utilising shareholders' equity to produce profits |
Assesses how efficiently a company uses its total capital (both equity and debt) to generate profits |
|
Capital |
Only considers the shareholder's capital |
Includes the total capital employed, including the company's debt |
|
Calculation Formula |
Net Income/Shareholder’s Equity |
EBIT/Capital Employed |
|
Signals |
A high ROE suggests efficient utilisation of equity |
A high ROCE may indicate effective management of overall capital |
|
Compatibility |
Works well for firms that rely heavily on equity |
Good for companies that have a lot of debt |
|
Risk |
A higher ROE could suggest increased financial risk |
Does not take into account financial risk |
Example of ROE and ROCE
Let us take an example to understand the calculation of ROE and ROCE of a company.
|
Balance Sheet |
Company A |
Company B |
|
Fixed Assets |
2,20,00,000 |
4,40,00,000 |
|
Current Assets |
60,00,000 |
1,20,00,000 |
|
Other Assets |
20,00,000 |
40,00,000 |
|
Total Assets |
3,00,00,000 |
6,00,00,000 |
|
Shareholders’ Equity |
70,00,000 |
1,40,00,000 |
|
Long Term Debt |
1,50,00,000 |
3,00,00,000 |
|
Total Capital Employed |
2,20,00,000 |
4,40,00,000 |
|
Current Liabilities |
80,00,000 |
1,60,00,000 |
|
Total Liabilities |
3,00,00,000 |
6,00,00,000 |
The company’s income statement is as follows:
|
Income Statement |
Company A |
Company B |
|
EBIT |
20,00,000 |
25,00,000 |
|
Interest Cost |
7,00,000 |
15,00,000 |
|
PBT (Profit Before Tax) |
13,00,000 |
10,00,000 |
|
Tax |
4,00,000 |
2,00,000 |
|
Net Profit |
9,00,000 |
8,00,000 |
Thus, by applying the ROE and ROCE formulas for Company A and Company B, we get:
|
Ratios |
Company A |
Company B |
|
ROE |
9,00,000/70,00,000 = 0.128 |
8,00,000/1,40,00,000 = 0.057 |
|
ROCE |
20,00,000/2,20,00,000 = 0.090 |
25,00,000/4,40,00,000 = 0.056 |
If you compare the balance sheets of both companies, you will see that Company B's balance sheet is twice as large as Company A's. Despite this, Company B cannot generate profits that match its large balance sheet size, leading to much lower ROE and ROCE than Company A.
To fix this, Company B should focus on improving its asset turnover ratio or boosting its profitability to raise its ROE and ROCE.
Another notable point is that the ROE and ROCE of Company B are almost the same. It means Company B is rewarding debt holders and equity holders equally, which is not fair since equity shareholders take on more risk. On the other hand, Company A shows a better balance. The ROE is 3.8% higher than the ROCE, justifying the extra risk taken by equity shareholders.
The Bottomline
While there is a difference between ROE and ROCE, both are valuable metrics for evaluating a company's financial health.
ROE emphasises the efficiency of equity utilisation, while ROCE provides insights into the overall efficiency of capital management. It is essential to consider both indicators to gain a comprehensive understanding of a company's financial performance and make informed decisions.
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