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Business News/ Money / Personal-finance/  DYK: How return on equity is different from return on capital employed
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DYK: How return on equity is different from return on capital employed

RoE and RoCE are two ratios that financial analysts consider while evaluating the financial efficiency of a company

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Measuring corporate performance includes assessing capital utilisation, which is a measure of profitability and shows how well a company is able to allocate capital to generate profits. The higher the ratio, the better it is for the company and therefore for shareholders. Return on equity (RoE) and return on capital employed (RoCE) are two ratios that financial analysts consider while evaluating the financial efficiency of a company. Directionally, both show similar trends but there are differences you should know while using one or another.

RETURN ON EQUITY (RoE)

Mathematically this is expressed by dividing the net profit after tax with the total shareholder’s equity capital. This is a measure for equity holders to ascertain the return they can generate on their investment. A company whose earnings are growing or has increasing earnings per share may seem like a good investment, but earnings growth itself doesn’t signify efficiency. If the earnings are growing along with an expanding capital base but at a slower pace, the company’s RoE will drop, and this signifies a drop in efficiency. An RoE that is trending lower could result from lower earnings or capital lying unallocated. While lower profits are a clear red flag, unutilised capital, too, should be examined. In other words, the company is unable to put to use incremental capital or reserves of accumulated profits to generate profits at the same rate as before.

RoE should be used to compare capital utilisation by a company on historical basis and also to compare with other companies.

While an RoE of around 20% is generally considered good, there is an industry bias. For example, a company in the information technology industry is likely to have a higher RoE than one in the manufacturing industry.

What RoE misses out is a company’s debt, which is where RoCE comes into play. While some amount of debt or leverage is required to improve growth, if a company takes on too much debt, then even though RoE could be increasing, cash profits might suffer.

RETURN ON CAPITAL EMPLOYED (RoCE)

Similar to RoE, this, too, measures capital utilisation but it takes into account both debt and equity capital. Mathematically, it is expressed as a ratio of earnings before interest and taxes to total assets less current liabilities. It shows how well a company generates earnings by utilising both debt and equity, and what returns creditors and shareholders can make. In terms of assessing a company’s financial efficiency, it can be used as the RoE is. It is also compared with the company’s weighted cost of capital—a lower RoCE is a red flag. Ideally, a company should have earnings above its cost of capital.

If the RoE and the RoCE are same, it may mean the company has no debt. Ideally, as the debt in an organisation increases, the RoE should increase and be higher than the RoCE. Both are important measures of a company’s profitability and should be considered together rather than in isolation.

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Published: 13 Apr 2016, 05:44 PM IST
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