Measuring corporate performance includes assessing capital utilisation, which is a measure of profitability and shows how well a company is able to allocate capital to generate profits. The higher the ratio, the better it is for the company and therefore for shareholders. Return on equity (RoE) and return on capital employed (RoCE) are two ratios that financial analysts consider while evaluating the financial efficiency of a company. Directionally, both show similar trends but there are differences you should know while using one or another.
RETURN ON EQUITY (RoE)
Mathematically this is expressed by dividing the net profit after tax with the total shareholder’s equity capital. This is a measure for equity holders to ascertain the return they can generate on their investment. A company whose earnings are growing or has increasing earnings per share may seem like a good investment, but earnings growth itself doesn’t signify efficiency. If the earnings are growing along with an expanding capital base but at a slower pace, the company’s RoE will drop, and this signifies a drop in efficiency. An RoE that is trending lower could result from lower earnings or capital lying unallocated. While lower profits are a clear red flag, unutilised capital, too, should be examined. In other words, the company is unable to put to use incremental capital or reserves of accumulated profits to generate profits at the same rate as before.
RoE should be used to compare capital utilisation by a company on historical basis and also to compare with other companies.
While an RoE of around 20% is generally considered good, there is an industry bias. For example, a company in the information technology industry is likely to have a higher RoE than one in the manufacturing industry.
What RoE misses out is a company’s debt, which is where RoCE comes into play. While some amount of debt or leverage is required to improve growth, if a company takes on too much debt, then even though RoE could be increasing, cash profits might suffer.
