ROE and ROCE – Know the Difference between ROE & ROCE
When it comes to investing for longer period in financial market, making decision without knowing the companies well; may result in losses. It is always important to evaluate a company on many parameters before making investment decision. Financial Statements – Balance Sheet, Profit & Loss statement, Cash Flow statement along with MD&A (Management Discussion and Analysis) of the company provides us with necessary information. It’s not essential to be expert of accountancy or good at numbers to understand the company. One has to be an informed investor to decode the numbers and understand the financial strength of the company.
As an investor, the financial ratios have become an essential part of our decision-making process as this gives us a comprehensive picture of company performance in various parameters. Here, let us understand two ratios which are important measures of company’s operational efficiency & future growth potential – ROE (Return on Equity) & ROCE (Return on Capital Employed).
ROE can be used to understand how the company uses its equity for the growth of the business. If ROE increases over a period, it simply means that the company increases shareholder value by reinvesting its earnings in order to make more profits. If ROE is less, it means that the company does not have an efficient management and hence makes mistakes by reinvesting earnings in unproductive assets.
ROE = Net income/Shareholder’s Equity
ROE tells how much money the company makes based on the money invested by investors in the company. Companies with high ROE are preferred by investors as they know that these are capable of providing higher profits.
One should also know that whenever the value of shareholder’s equity decreases, ROE increases. Higher ROE means that the company is efficiently using shareholder’s equity. It also shows that the company is using its retained earnings in an efficient manner. If the company maintains its profits and also if there is an increase in ROE, this indicates that the company is using retained earnings to generate revenues. On the other hand, if the company keeps retained earnings in its reserves, then ROE will start decreasing. Let us also learn about ROCE now to understand the difference between the two.
Return on capital employed, or ROCE, is a long-term profitability ratio that measures how effectively a company uses its capital. The metric tells you the profit generated by each Rupee (or other unit of currency) employed. ROCE simply indicates how efficiently a company generates profit by using its capital.
ROCE = EBIT/Capital Employed
EBIT – Earnings before interest and taxes
ROCE is mainly used to understand the financial strength of different companies within the same sector. Merely using EBIT to choose a company for investment is not a good idea. Profitability ratios like ROE and ROCE of companies have to be analysed to know the real picture. The higher is the ROCE, the higher the probability or profits. Lenders, debt holders are also taken in to consideration in calculating ROCE. And this ratio is used to evaluate the performance of companies with significant debt.
|ROE vs ROCE|
|Income||The income considered here is the Profit after all the Interest and Taxes are charged.||The Income taken into consideration here is the earnings before the taxes and interests are charged.|
|Taxes & Interest||In a situation where the government has increased the taxes, the ROE will take into effect its impacts.||Changes in Interest and taxes do not impact the ROCE. The ROCE is only impacted by the changes in operating expenses like wages etc.|
|Capital||The ROE considers only the shareholder capital employed.||The ROCE considers the total capital employed (Including debt) by the company.|
|Ratio||Effective management of shareholders’ capital.||It shows the efficiency of a business operation.|
|Stakeholder Significance||The ROE is of more significance to the shareholders as it shows them the returns the company provides for every Rs.1 they invest. It is of greater significance to shareholders as it shows them what is left for them after the debt is serviced.||The ROCE is of significance to both the shareholders and the lenders. This is because the ROCE also shows the effectiveness of the total capital employed in the company.|
As Warren Buffett explains, “The closer the ROE and the ROCE are to each other, you can be rest assured that the company is aligning the interests of its stakeholders and harnessing it in the larger interests of the company.”