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Return on Capital Employed (ROCE) and Return on Equity (ROE) or Return on Net Worth (RONW) are used to measure the profitabilty of a company based on the funds with which the company conducts its business. While each ratio is a metric to measure returns, ROCE measures the overall return and ROE measures the return attributable only to the shareholders.
ROCE measures a company’s profitability purely from its operations by calculating the return generated on the total capital invested in the business (i.e. equity + debt). When calculating the ROCE on a consolidated basis, the numerator is the OPERATING PROFIT generated by the company along with its subsidiaries. Accordingly, thedenominator will be the sum of, net worth (i.e. share capital + reserves & surplus), minority interest and long term debt.
ROCE measures the overall profitability of the company’s operations while ROE draws attention to the return generated by the owners (i.e shareholders) on their investment in the business. A company may operate with a very healthy ROCE but it may not add much value to a shareholder if most of the income generated is used up in servicing the company’s debt (i.e. interest charges).
Example: Let’s take the example of two companies operating with the same amount of capital but different capital compositions. Company A operates with a debt of Rs. 800 and total equity of Rs. 200 while company B operates with a debt of Rs. 200 and total equity of Rs. 800.
Even though, company B reports a higher operating profit and profit after tax figures, the shareholders of company A will earn a higher return on their investment. This is because company A operates with a smaller equity base. Download full presentation on Efficiency Ratios here
Capital Employed (CE) can be calculated in a variety of ways such as (1) CE = Fixed Assets + Working Capital (2) Total Assets – Current Liabilities (3) Equity + Non-Current Liabilities or the approach followed by us – (4) Net Worth + Minority Interest + Long term Debt. This approach excludes deferred tax liabilities and long term provisions in the denominator, it also excludes short term debt and overdraft facilities. This gives a clear picture of the returns being generated from a long term perspective. That said, and for this reason, it is important to look at the current ratio which measures the working capital, to check if the company is regularly able to meet its short term debt obligations.
A more accurate form of ROCE is the Return on Average Capital Employed (ROACE), which takes the average of opening and closing capital employed as the denominator.