Return on Equity (ROE) and Return on Capital Employed (ROCE) are both key financial ratios used to assess the profitability and efficiency of a company, particularly from the perspective of investors and analysts in the stock market. However, they focus on different aspects of a company’s financial performance:
Return on Equity (ROE)
- Definition: ROE measures the amount of net income returned as a percentage of shareholders’ equity. It essentially indicates how well a company uses investments to generate earnings growth.
- Formula: ROE=Net Income/ Shareholders’ Equity
- Focus: It focuses on the profitability relative to the equity held by the shareholders. It’s a measure of how effectively the company is using the money invested by its shareholders to generate profits.
- Usefulness: Particularly valuable to equity investors since it gives them an idea of how well their capital is being used. Higher ROE values are generally preferable, indicating that the company is efficient in generating profits from shareholders’ equity.
Return on Capital Employed (ROCE)
- Definition: ROCE measures a company’s profitability and the efficiency with which its capital is employed. It compares earnings before interest and taxes (EBIT) to capital employed, providing insight into how well a company is generating profits from its total capital.
- Formula: ROCE=EBITA/ (Total Assets−Current Liabilities)
- Focus: It looks at the return generated from the total capital employed, including both equity and debt. This provides a more comprehensive view of how efficiently a company is using all its sources of capital to generate earnings.
- Usefulness: Useful for both debt and equity investors as it shows how effectively a company is using all of its capital to generate profits. It’s particularly relevant for companies with significant amounts of debt.
Key Differences
- Basis of Calculation: ROE uses net income and shareholders’ equity, focusing on equity financing. ROCE uses EBIT and total capital employed, thus considering both equity and debt financing.
- What They Measure: ROE measures how effectively the company uses shareholders’ equity to generate profits, while ROCE measures how efficiently the company uses all its employed capital, including debt, to generate earnings.
- Usefulness: ROE is more relevant for equity investors concerned with the returns on their investment. ROCE is important for all investors, including creditors and equity holders, as it provides a broader view of the company’s efficiency in using its capital.
Both ratios are important in analyzing a company’s financial health and operational efficiency, but they serve different purposes and provide insights from different perspectives.
