This post is the extension of one of my previous post on RoE. I discussed about RoE and how debt can show higher RoE and sometimes misleads us.
We have seen that when there is a debt on the books of the company then RoE will show much higher number. Because calculations of RoE not consider debt portion which is there on the book of company. So that we need to check RoCE.
So let’s try to understand RoCE in a simple manner.
What is RoCE (Return on Capital Employed)?
“Return on capital employed (RoCE) is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed.”
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
“Capital Employed” as shown in the denominator is the sum of shareholders’ equity and debt liabilities; it can be simplified as (Total Assets – Current Liabilities). – Investopedia
RoCE stands for Return on Capital Employed that means calculating returns on all capital (Equity + Debt) used for generating profits. So RoCE having consideration of debt which is not in RoE calculations.
In calculation of RoE, we took Net profit and shareholders’ equity but for the calculation of RoCE, we took Earnings Before Interest and Tax (EBIT) and Capital Employed (Equity + Debt).
We can see that if we are having debt on our book then RoE (%) shows higher because of not consideration of debt portion. Thus, RoCE (%) also we need to check for getting better understanding.
Debt can magnify returns in good situation but as a when situations start worsening it creates problems. So that company need to take debt very carefully. Generally, we can find that if company having higher RoE (%) compare to RoCE (%) then that because of debt portion.
As debt portion increases on balance sheet then difference between RoE (%) and RoCE (%) also start increasing.
We always focus on higher RoE (%) but with that also we need to check debt level and RoCE (%) so that we can able to get better understanding about the business situations. If RoE (%) magnify due to higher level of debt then we must have to be careful because debt always help in favorable situations and as a situation starts worsening, debt first in queue for giving pain.
Not only RoE (%) or RoCE (%) help us, we need to check both together. Sometimes RoCE (%) shows positive return but due to higher debt and worsening situations RoE (%) give us a prior signal. And as RoE (%) is lower compared RoCE (%) then we can say that company facing problem due to debt burden. When RoCE (%) falls below interest rate (%) from then problems for the company starts arising.
We need to check both RoE (%) and RoCE (%) together because sometimes RoE (%) provide us a prior signal of worst situations and sometimes RoCE (%) help us to protect us from getting attracted towards higher RoE (%). And never gets attracted with higher RoE (%) that can mislead us sometimes.