Understanding ROCE,ROIC,ROE & ROA: What These Ratios Tell Us About Companies

1. Introduction:

Financial ratios are critical tools used to measure the financial performance of companies. They provide investors with insights into the profitability and efficiency of a company’s operations. Four of the most widely used return-based financial ratios are Return on Capital Employed (ROCE), Return on Invested Capital (ROIC), Return on Assets (ROA), and Return on Equity (ROE).

2. What Do ROCE, ROIC, ROA, and ROE tell us about companies?

ROCE, ROIC, ROA, and ROE are all return-based financial ratios that measure a company’s profitability and efficiency in different ways:

ROCE measures the Return a Company Generates from its Total Capital Employed, Including both Equity and Debt. It shows how efficiently a company uses its capital to generate profits.

ROIC measures the return a company generates from the money invested in the business by both equity and debt investors. It shows how well a company is utilizing the money it has received from its investors.

ROA measures the return a company generates from its assets. It shows how efficiently a company uses its assets to generate profits.

ROE measures the return a company generates from the money invested by its equity shareholders. It shows how efficiently a company is using the equity it has received from its shareholders to generate profits.

3. Calculation with examples

To calculate these ratios, we need to use the following formulas:

ROCE = EBIT / (Total Assets – Current Liabilities)

ROIC = NOPAT / (Invested Capital)

ROA = Net Income / Total Assets

ROE = Net Income / Total Equity

Let’s look at some examples of how these ratios can be calculated in rupees:

Example 1:

ABC Ltd has a net income of Rs. 5 crore, total assets of Rs. 20 crore, and total equity of Rs. 10 crore. Its ROA and ROE can be calculated as follows:

ROA = Net Income / Total Assets = Rs. 5 crore / Rs. 20 crore = 0.25 (ROA = 0.25 x 100 = 25%)

ROE = Net Income / Total Equity = Rs. 5 crore / Rs. 10 crore = 0.5 (ROE = 0.5 x 100 = 50%)

(Note. To convert the final Ratios into Percentage terms, simply multiply them by 100.)

Example 2:

XYZ Ltd has EBIT of Rs. 10 crore, total assets of Rs. 50 crore, and current liabilities of Rs. 5 crore. Its ROCE can be calculated as follows:

ROCE = EBIT / (Total Assets – Current Liabilities) = Rs. 10 crore / (Rs. 50 crore – Rs. 5 crore) = 0.22 (ROCE = 0.22 x 100 = 22%)

Example 3:

PQR Ltd has a NOPAT of Rs. 7 crore and invested capital of Rs. 35 crore. Its ROIC can be calculated as follows:

ROIC = NOPAT / Invested Capital = Rs. 7 crore / Rs. 35 crore = 0.2 (ROCE = 0.22 x 100 = 20%)

4. Comparison with bank rate & inflation:

The bank rate is the rate at which commercial banks can borrow money from the central bank. Inflation is the rate at which the general level of prices for goods and services is rising. These rates can have a significant impact on the financial performance of companies.

ROCE, ROIC, ROA, and ROE are all return-based financial ratios that measure a company’s profitability and efficiency. They can be compared with bank rates and inflation to determine whether a company is performing well or not. If a company’s return-based ratios are higher than the bank rate and inflation rate, it indicates that the company is generating a return that is higher than the cost of borrowing and the rate of inflation, which is considered good.

On the other hand, if the company’s return-based ratios are lower than the bank rate and inflation rate, it may indicate that the company is not generating a sufficient return to cover its cost of borrowing and keep up with inflation. This can be considered a red flag for investors.

5. Interpretation with examples:

Let’s take the examples from earlier and interpret the ratios:

Example 1:

ABC Ltd has a ROA of 0.25 and a ROE of 0.5. This indicates that the company is generating a 25% return on its assets and a 50% return on the equity invested by shareholders. This is considered good and shows that the company is using its assets and equity efficiently to generate profits.

Example 2:

XYZ Ltd has a ROCE of 0.22. This indicates that the company is generating a 22% return on the capital employed in the business, which includes both equity and debt. This can be considered a reasonable return, but it would depend on the industry and the company’s competitors.

Example 3:

PQR Ltd has a ROIC of 0.2. This indicates that the company is generating a 20% return on the money invested in the business by both equity and debt investors. This is considered a good return and shows that the company is utilizing its capital efficiently to generate profits.

6. Good, Bad, and Reasonable Ratios

7. Why is ROIC better among these ratios? Explanation with examples:

ROIC is considered a better ratio compared to the other three ratios because it focuses on the money invested in the business by both equity and debt investors. It takes into account the capital structure of the company and provides a more accurate picture of how well a company is utilizing its capital to generate profits.

For example, consider two companies: Company A and Company B. Both companies have a ROE of 20%, but Company A has a debt-to-equity ratio of 1:1, while Company B has a debt-to-equity ratio of 3:1. In this case, Company A is using more equity to generate the same return, which is a better situation compared to Company B, which is using more debt.

However, if we look at ROIC, which takes into account both equity and debt capital, it gives a more accurate picture of the situation. Suppose Company A has an ROIC of 15%, and Company B has an ROIC of 12%. In this case, Company A is still performing better, but the difference is not as significant as it was in the case of ROE.

Another advantage of ROIC is that it takes into account the taxes paid by the company. Companies with higher levels of debt may have a lower tax burden due to the tax-deductibility of interest payments. ROIC captures this benefit and provides a more accurate picture of a company’s profitability.

For instance, consider two companies, Company X and Company Y. Both companies have the same earnings before interest and taxes (EBIT) of Rs. 100, but Company X has no debt, and Company Y has a debt-to-equity ratio of 2:1.

Company Y pays an annual interest of Rs. 20 on its debt, and the tax rate is 30%. In this case, Company X has a higher ROE and ROCE due to its lack of debt, but Company Y has a higher ROIC due to the tax benefit it receives from its debt. Thus, ROIC provides a more accurate picture of a company’s profitability in such cases.

ROIC is a better ratio than the other three ratios because it considers both equity and debt capital and provides a more accurate picture of a company’s profitability, taking into account the capital structure and taxes paid. It is an essential tool for investors to assess a company’s profitability

8. Conclusion:

Return-based financial ratios such as ROCE, ROIC, ROA, and ROE are critical tools used to measure a company’s financial performance. They provide investors with insights into the company’s ability to generate profits and how well it is utilizing its assets and capital to do so.

When interpreting these ratios, it is essential to compare them to industry benchmarks and historical data to determine if they are good, bad, or reasonable. Additionally, it is crucial to compare the ratios to the bank rate and inflation rate to see if the company is generating a return that is higher than the cost of borrowing and inflation.

While all four ratios are essential, ROIC is considered a better ratio compared to the others as it takes into account both equity and debt capital and provides a more accurate picture of a company’s ability to generate profits.

Overall, return-based financial ratios provide investors with critical information that can help them make informed investment decisions. It is essential to analyze these ratios along with other financial and non-financial metrics to gain a holistic view of a company’s performance and future prospects.

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9. Questions & Answers

What are ROCE,ROIC, ROA, and ROE?

ROCE, ROIC, ROA, and ROE are return-based financial ratios that measure a company’s profitability and efficiency in different ways.

How is ROCE calculated?

ROCE is calculated as EBIT divided by total assets minus current liabilities.

What does ROA measure?

ROA measures the return a company generates from its assets.

Why is ROIC considered a better ratio compared to the others?

ROIC is considered a better ratio compared to the others as it takes into account both equity and debt capital and provides a more accurate picture of a company’s ability to generate profits.

What is the significance of comparing these ratios to industry benchmarks and historical data?

Comparing these ratios to industry benchmarks and historical data helps to determine if they are good, bad, or reasonable.

How can investors use these ratios to make informed investment decisions?

Investors can use these ratios to gain insights into a company’s ability to generate profits and how well it is utilizing its assets and capital to do so. They can analyze these ratios along with other financial and non-financial metrics to gain a holistic view of a company’s performance and future prospects.

What are some examples of good, reasonable, and bad ratios for ROCE, ROIC, ROA, and ROE?

Good, reasonable, and bad ratios for ROCE, ROIC, ROA, and ROE can vary by industry, but some general guidelines are provided in the blog post:

ROCE: >15% (Good), 10-15% (Reasonable), <10% (Bad)

ROIC: >10% (Good), 5-10% (Reasonable), <5% (Bad)

ROA: >5% (Good), 2-5% (Reasonable), <2% (Bad)

ROE: >15% (Good), 10-15% (Reasonable), <10% (Bad)