Difference Between ROCE and ROE

07 June 2024
5 min read
Difference Between ROCE and ROE
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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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