Difference Between ROCE and ROE

A recent study showed that companies with rising ROCE delivered 25% annualised returns to their shareholders, compared to 8% returns for companies with a declining ROCE. When discussing profits, the terms ROE and ROCE are frequently used.
At first, they seem the same as both are used to measure how efficiently a company is making profits, but they have a major difference: ROE only uses shareholders’ equity, but for ROCE, the total capital employed is used. 

In this article, let’s break down the two terms, their formulas, differences, and utility.

What is Return on Equity (ROE) ?

ROE is a financial ratio that measures how a company is using its shareholders’ funds to generate profit.
A high ROE shows that the resources are being utilised effectively to generate returns. However, excessively high ROE might be a result of adding too much debt in the capital structure. Only using the ROE is not enough to understand the profit-generating ability of a company.

The given formula is used to calculate the ROE:

ROE = (Net Income/ Shareholders’ Equity)*100

What is ROCE (Return on Capital Employed)?

ROCE measures the returns generated on the total capital of a company. Instead of just equity, total capital employed is used for the calculation of ROCE, so it provides a better overview of a company’s financial situation.

The formula to calculate ROCE is:

ROCE = (EBIT / Capital Employed)*100

where, Capital employed = Equity + Debt

Key Differences Between ROCE and ROE

The following parameters are used to compare the key differences between ROCE and ROE:

Capital Base: Equity vs Capital Employed

• ROE measures the profit based on the shareholders’ equity only.
• The total capital is used for the calculation of ROCE. It is the sum total of debt and equity.

In simple terms, ROE shows what the shareholders are earning, and ROCE shows how efficiently the total capital is being used to generate profits.

Profit Metric: Net Income vs EBIT

• For the calculation of ROE, Net Income is used. It is the final metric after all deductions, and shows what the shareholders are receiving at the end.
• Earnings Before Interests and Taxes (EBIT) is used when we have to measure the ROCE. It means the earnings made before any deductions, so using it gives a better overview of the company’s operating efficiency.

Impact of Debt / Leverage

The amount of debt in the capital structure is known as the financial leverage.

• Higher financial leverage increases the ROE as the profit is divided by a smaller quantity of equity.
• Due to the interest payments, financial leverage may shrink the profits and decrease the ROCE.

Sensitivity to Capital Structure

• ROE is more sensitive to capital structure changes. Any changes in the equity-debt composition are reflected in the ROE.
• The capital structure has a lesser effect on the ROCE. Unless the total capital is being changed, ROCE remains the same.

The following table will help you better grasp the differences between the two:

Parameter	ROE	ROCE
Capital Base	Considers only the shareholders’ equity	Considers the total capital (equity and debt)
Profit Metric	Based on the net income	Based on EBIT
Debt Impact	Changes in debt highly affect the ROE	ROCE is less affected by changes in debt
Sensitivity to Capital Structure	Highly sensitive to any changes in the capital structure	More stable, only changes when the total capital is changed

How to Calculate ROE & ROCE (with Examples)

Let’s look at two examples to understand how ROE and ROCE are calculated:

Example 1 – Simple Case

Let’s take the example of company X, which has the following:

EBIT = ₹ 25 lakh

Net Profit = ₹ 15 lakh

Shareholder’s Equity = ₹ 60 lakh

To calculate the ROE, we will use the formula:

ROE = (Net Profit/ Shareholders’ Equity)*100

ROE = (15/60)*100 = 25%

To calculate the ROCE, we will use the formula

ROCE = (EBIT /Capital Employed)*100

ROCE = (25/60)*100 = 41.67%

Example 2 – With Debt & Leverage

Now let’s take the example of company Y, which has the following:

EBIT = ₹ 40 lakh

Net Profit = ₹ 30 lakh

Shareholder’s Equity = ₹ 60 lakh

Debt = ₹ 60 lakh

To calculate the ROE, we will use the same formula as the first example :

ROE = (30/60)*100 = 50%

For calculating ROCE, we will need the total capital

Total Capital = ₹ (60+60) lakh = ₹ 120 lakh or ₹ 1.2 Cr

Now, let’s use the total capital to find the ROCE

ROCE = (40/120)*100 = 33.34%

In this case, the debt has increased the total capital and reduced the equity in the company. The reduced amount of equity leads to a ROE which is higher than the ROCE.

Trend / Time Series Analysis

The direction in which anything moves with respect to a time series is called its trend. This trend can indicate an increase (upwards trend), a decrease (downwards trend), or stability (horizontal trend). 

The trend represents an underlying pattern in the long run, independent of any short-term changes or fluctuations.

For ROE and ROCE,

• An increasing trend in ROE means that the shareholders are earning higher returns on their investments and vice versa.
• Rising ROCE means that the company has good management of its capital structure with financial leverage, resulting in higher returns over time.
• Increasing ROE with decreasing ROCE can be a threat, as the introduction of more leverage with time can eat away at the profits. Debt brings the burden of interest payments, which shrinks the earnings.

What’s a Good ROE or ROCE? Benchmarks by Industry

There is no fixed good ROE or ROCE. Both metrics are used to calculate profits, but their ideal range differs based on the business model and industry.

Some of the industry benchmarks for them are:

Industry	ROE	ROCE
Fast Moving Consumer Goods (FMCG)	28%-31%	33%-36%
Information Technology (IT)	23%-27%	30%-33%
Metals & Mining	12%-16%	18-22%
Financial Services	15% – 18%	7%-11%
Consumer Durables	21% – 25%	26% – 30%

These benchmarks are general ranges of different industries. A company can compare its own ROE and ROCE with these benchmarks to get a better understanding of its own profitability.

How to Improve ROE & ROCE

To improve the ROE and ROCE, a company can use the following measures:

Managing Costs & Margins

• Lowering Costs : Cutting down costs and reducing wastes raises the earnings, which result in higher ROE and ROCE.
• Improving Margins : Focusing on higher profit-generating products and a better pricing strategy can increase the returns without any additional costs.

Optimising Capital Structure / Debt Use

• Optimising the capital structure is one of the key forces behind improving the ROE and ROCE.
• Increasing the leverage in reasonable amounts helps in improving both ROE and ROCE over time.
• When the debt increases too much, it lowers the profitability. The management should try to establish and maintain a capital structure that optimises the returns.

Boosting Operating Efficiency & Asset Turnover

• Improving the production output helps in generating more sales and thus, more returns.
• A higher rate of asset turnover means that more sales are increasing without changing the company’s assets.
• By improving the operating efficiency and asset turnover, the earnings also increase which results in better ROE and ROCE.

In simple terms, cutting down costs, improving operational efficiency, and optimising the capital structure help a company to improve its ROE and ROCE.

Conclusion

Both ROE and ROCE are used to calculate the profit, but understanding the differences between them is important to better analyse the efficiency of a company. ROE measures the returns earned on shareholders’ funds, while ROCE tells how effectively the company is using its total capital. A company should make use of both ratios to dive deeper into its profit-generating efficiency.

A company should look to improve both ratios with time, as they are crucial for its financial health and sustainability.

FAQs