Capital is required to start up and run business operations. Capital for such business operations may be obtained using many methods such as issuing shares, bonds, loans, owner’s contributions, etc. It is important to consider the return that a company derives from such forms of capital that are invested in the business. Return on equity (ROE) and Return on capital employed (ROCE) are two such ratios that measure a company’s profitability based on the equity that is invested in a business. The following article offers a clear overview of both these terms and explains the similarities and differences between ROE and ROCE.
What is ROE (Return on Equity)?
Return on equity (ROE) is a formula very useful for shareholders and investors who invest in the firm’s equity, as it allows them to see how much return they can obtain from their equity investment. In other words, ROE measures a company’s profitability as a percentage of the equity and total ownership interests in the business. Return on equity is a good measure of the company’s financial stability and profitability, as it measures profits made by investing shareholder’s funds. Return on equity is calculated by the following formula.
Return on Equity = Net Income/Shareholder’s Equity
Net income is the revenue generated by a firm, and shareholder’s equity refers to the capital contributed to the firm by shareholders. As an example, if a company XYZ is making a profit of $1 Million for the past year, and the total equity in the firm was $50 Million, the ROE would be 2%.
What is ROCE (Return on Capital Employed)?
Return on capital employed (ROCE) displays the company’s ability to generate profits from all capital that it employs. ROCE shows the company’s profitability when taking into consideration the total equity as well as the liabilities and debt within which the company operates. ROCE is calculated as follows.
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
In the above formula, ‘capital employed’ is the total of shareholder’s equity and debt, and it is equal to Total Assets – Current Liabilities. A high ROCE is evidence of efficient use of capital, and the company’s ROCE must always be greater than the cost of capital. ROCE is useful when comparing the financial performance of firms that operate in capital intensive industries and hold large amounts of debt.
What is the difference between ROE and ROCE?
ROE and ROCE are profitability ratios that measure the company’s profitability in relation to the funds invested into the business. ROE takes into consideration the profits generated from the shareholder’s equity whereas ROCE takes into consideration profits generated from all capital that it employs including the company’s debt. Both ROE and ROCE are used by investors, institutions and stakeholders when considering a company’s efficiency in generating profits from funds invested, and are frequently used when deciding between investment options. A firm must strive to achieve higher ROE and ROCE (the higher, the better), but should at least be higher than the cost of capital. ROCE is seen to be a more comprehensive evaluation of profitability as ROCE, unlike the ROE that only takes into consideration the equity, takes the total debt and liabilities too into consideration. ROCE provides a more accurate view of profitability for a firm with large amounts of debt.
Summary:
ROE vs ROCE | Return on Equity vs Return on Capital Employed
• Return on equity (ROE) is a formula very useful for shareholders and investors who invest in the firm’s equity, as it allows them to see how much return they can obtain from their equity investment.
• In other words, ROE measures a company’s profitability as a percentage of the equity and total ownership interests in the business.
• Return on capital employed (ROCE) displays the company’s ability to generate profits from all capital that it employs.
• ROCE shows the company’s profitability when taking into consideration the total equity and debt within which the company operates.
• Both ROE and ROCE are used by investors, institutions and stakeholders when considering a company’s efficiency in generating profits from funds invested, and are frequently used when deciding between investment options.
• ROCE is seen to be a more comprehensive evaluation of profitability as ROCE, unlike the ROE that only takes into consideration the equity, takes into consideration the total debt and liabilities.
• ROCE provides a more accurate view of profitability for a firm with large amounts of debt.