ROCE (Return on Capital Employed) and ROE (Return on Equity) are two important financial ratios used to evaluate a company's profitability and efficiency in using capital. However, they differ in terms of calculation, significance, and application.
1. Return on Capital Employed (ROCE)
Definition:
ROCE measures how efficiently a company uses its total capital (equity + debt) to generate profits. It evaluates the company's overall profitability and is useful for comparing firms with different capital structures.
Formula:
ROCE = (Earning Before Interest and Taxes (EBIT)/Capital Employed)*100
Where:
- EBIT (Earnings Before Interest and Taxes): Also known as Operating Profit, it represents the profit generated before paying interest and taxes.
- Capital Employed: Total assets minus current liabilities (or Equity + Long-term Debt).
Example:
Suppose a company has:
- EBIT = ₹500,000
- Total Assets = ₹3,000,000
- Current Liabilities = ₹1,000,000
- Capital Employed = Total Assets - Current Liabilities = ₹2,000,000
ROCE = (500,000/2,000,000)*100 = 25%
Significance:
- A higher ROCE indicates better efficiency in utilizing capital.
- Useful for comparing capital-intensive industries (e.g., manufacturing, energy).
- Helps investors determine whether a company generates sufficient returns on total capital invested.
2. Return on Equity (ROE)
Definition:
ROE measures the return a company generates on shareholders' equity, indicating how effectively it uses investors' funds to generate profits.
Formula:
ROCE = (Net Profit/Shareholder's Equity)*100
Where:
- Net Profit (Net Income): Profit after deducting interest, taxes, and all expenses.
- Shareholders’ Equity: Total equity held by shareholders (Total Assets - Total Liabilities).
Example:
Suppose a company has:
- Net Profit = ₹400,000
- Shareholders’ Equity = ₹1,500,000
ROE = (400,000/1,500,000)*100 = 26.67%
Significance:
- A higher ROE means the company is effectively using shareholders’ funds.
- Useful for equity investors to evaluate potential returns.
- Best for comparing companies in the same industry.
Key Differences Between ROCE and ROE
| Feature | ROCE | ROE |
|---|---|---|
| Definition | Measures return on total capital (debt + equity) | Measures return on shareholders’ equity only |
| Formula | EBIT / Capital Employed | Net Profit / Shareholders' Equity |
| Focus | Efficiency in using total capital | Profitability for shareholders |
| Ideal For | Comparing companies with different capital structures | Evaluating equity investment potential |
| Impact of Debt | Accounts for both debt and equity | Excludes debt and considers only equity |
Which One is Better?
- If a company has high debt, ROCE is more relevant because it considers both debt and equity.
- If you are an equity investor, ROE is more useful as it measures the profitability of shareholders’ funds.
- Ideally, a company should have both high ROCE and high ROE, indicating strong overall profitability and efficient use of equity.
Final Thought
Both ROCE and ROE are essential profitability metrics. ROCE is crucial for assessing a company’s efficiency in using total capital, while ROE helps investors understand the return on their investments. A well-balanced company should maintain a high ROCE and ROE while managing debt efficiently.