Profitability is a measure of the success of the business. In order to survive and compete, a business must remain consistently profitable. In other words, profit is non-negotiable. The analysis of the profitability of a company is essentially based on two key ratios – ROE (Return on Equity) and ROCE(Return on capital employed .In this blog , we will delve deep into these profitability ratios by exploring their determinants , and their role in gauging a company’s financial performance.
ROE-
Formula – Net Income / Shareholders’ Equity
Shareholder Equity = Total assets – Total liabilities
ROE basically measures how efficiently companies use shareholder’s funds (equity) to generate profit. Companies with a higher Return on equity than their peers may be good investments.
Let’s break down the formula.Net income refers to profit after tax (and other expenses). Shareholder’s funds or Shareholder equity represents the funds invested in the company through stock purchases. A company may launch an IPO (initial public offering) and sell stocks to raise capital. Shareholder’s Equity also consists of outstanding shares, additional paid-in capital, retained earnings and treasury stock. It is evident that an increase in Net income or a decrease in Shareholder Equity will cause ROE to increase.
Another way to dissect the formula is to use DuPont analysis. It consists of three components –
- Net Profit Margin (PAT/Net Sales)
- Total Asset Turnover Ratio
- Equity Multiplier/Financial Leverage(Total assets/Net worth)
Formula of ROE in terms of DuPont Analysis –
Net Profit Margin * Total Asset Turnover Ratio * Equity Multiplier (Financial Leverage).
This formula is very insightful as it perfectly lays out all the factors that a company can manipulate to achieve a good ROE. Therefore, we must carefully examine changes in each and every component. For instance, a company might increase borrowing (financial leverage) to increase ROE. However, this may be dangerous as the funds borrowed must be repaid with interest. A company may manipulate the depreciation rate to increase ROE. ROE can go up if there’s negative retained profit(due to inconsistent profits) that causes a decrease in Shareholder Equity.
What does ROE tell us and how should we use it?
ROE shows us the financial soundness of a firm – whether or not a firm can create value for its shareholders by efficiently deploying capital. We can analyse a company’s growth by comparing current ROE to historical ROEs (over 10 years). A rising ROE tells us that the company is flourishing financially. In order to find out the trigger, the DuPont formula can be used. Additionally, a company’s ROE can also be compared to that of competitors in that specific industry. This is crucial as ROE may vary from industry to industry.
ROCE – An alternative to ROE
Formula – EBIT / Capital Employed
Capital employed = Total assets – current liabilities
Although the two ratios are extremely similar when it comes to the formula, there are certain differences that make ROCE a superior ratio. ROCE, unlike ROE, refers to how efficiently all available capital (not just shareholder equity) is used to generate profit. This is because long term debts are also taken into consideration. Therefore, capital employed can also be written as –
Capital Employed = Shareholder Equity + long term debts
Instead of using net income, ROCE uses EBIT(Earnings before interest and tax). This ratio is not only helpful to shareholders but also companies as it helps to gauge how equity and debt are being used. This is why ROCE is useful in analyzing capital – intensive businesses such as utilities and telecommunications.
ROCE can be used to assess the financial performance of companies with different capital structures. A ROCE greater than the ROE indicates that the overall capital is being serviced at a higher rate than the equity shareholders.
However, ROCE can be manipulated as well. For instance ,classification of long term liabilities as current liabilities is an example of such accounting manipulation. ROCE may vary from industry to industry and one cannot compare it with sectors and markets. Unlike ROE, which is primarily concerned with the use of equity, ROCE revolves around the use of assets.
ROE vs. ROCE –
| ROE | ROCE |
| Measures how efficiently a company uses equity (shareholder’s equity) | Measures how efficiently a company uses all capital employed to generate profit |
| Uses Net profit for calculation | Uses EBIT for calculation |
| Indicator of effective management of equity financing | Mirror image of long-term assets of a company |
Moreover, a more comprehensive picture of the financial situation of a firm is also painted by comparing ROCE and ROE. Warren Buffet is also known for deeply analyzing these metrics. For instance, Mr. Buffet prefers companies with ROE and ROCE that are very close to one another. Other experts have also voiced their take and opinion on ROCE and ROCE. ”A company with high debt should be analyzed using RoCE whereas a company with little debt should be analyzed using ROE,” said Vivek Mahajan, head of research at Aditya Birla Money.
The information provided by Finance Voyager is for information purposes only and is not intended for advice. Finance Voyager also does not make any recommendation or endorsement as to any investment, advisor or other service or product. The information is only for educational purposes and not buy or sell recommendations.
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