As investors, the financial ratios have become an essential part of our decision-making process. This is because ratios measure and give us a more comprehensive picture of companies’ operational efficiency, liquidity, stability, and profitability in comparison to the raw financial data from various statements.
Today we look at two profitability ratios namely the ROE and the ROCE with an attempt to better understand them
Return on Equity (ROE)
The Return on Equity ratio enables us to measure a company’s performance by dividing the annual net returns by the value of the shareholders’ equity. The ROE ratio helps us to judge the effectiveness of a company’s management to use the shareholder contribution available in order to generate profits
— ROE Formula
Return on equity (ROE) can be calculated as Net Income of a company divided by its Shareholder Equity.
Net Income: The Net Income considered here is the income remaining after the taxes, interest, and dividend to preference shareholders is paid out.
Shareholder Equity: Assets – Liabilities
ROE brings together two financial statements. It includes the Net income from the income statement and the shareholders’ equity from the Balance Sheet.
Example to understand ROE
Take two companies A and B in the ice cream business. Both companies have made a profit of 20 lacs for the financial year 2019-20. But how are we to compare the greater of the two in this scenario. After taking a closer look we find that the investments received by the 2 companies are: Company A – 1 crore and Company B – 2 crores.
The ROE computed for company A is 0.2 and for company, B is 0.1.
This puts the returns from the two companies in a whole new perspective. Despite both of the companies reporting the same profits, the management of Company A is more efficient in converting the money invested into profits. Hence, it would be wise to invest in Company A as management is more efficient in generating profits.
Return on Capital Employed (ROCE)
The Return on Capital Employed ratio shows us the effectiveness of a company’s allocation of capital. The ROCE ratio is acquired by dividing a company’s operating income by the capital employed.
Return on capital employed can be calculated by dividing EBIT (Operating Income) by its Capital Employed.
Operating Income: The operating income is what we get after the total sales is deducted by the operating expenses like wages, depreciation, and cost of goods sold. In other words, it is the Earnings before interest and tax charged (EBIT).
Capital Employed: Assets – Current Liabilities or Equity + Debt.
Example to understand ROCE
Let us take a similar example as that taken in the case of ROE. The same companies A and B are in the ice cream business. They have earned a profit of 20 lacs and have an investment as follows: Company A -1 crore and Company B – 2 crores. But in addition to this, the debt taken by the companies is Company A – 3 crores in loans and Company B – 1 crore in loans.
Using ROE and ROCE – The right way?
A shareholder may also use the ROE and the ROCE ratios in comparison to each other. When the ROCE ratio is greater than the ROE it signifies that a major portion of the profits earned is diverted to service the debt of the company. This would not be taken positively by shareholders. However, it is also important to consider that a company with a high ROCE ratio is able to raise debt at attractive terms. The high ROCE improves the valuations of a company. This is because it shows that the company can easily raise debt for its future operations.