ROE Vs ROCE
Return on equity and return on capital employed are both profitability ratio that use by management, investors and shareholders to assess how entity use equity and capital. The high of these ratios, the more efficiency of equity and capital are used. Return on equity using the relationship between net income for the period with averages of equity or equity at the end of the period. Return on capital employed on the other hand use profit before interest and tax for the period, and capital employed. Although these two ratios use to assess profitability of entity, they both are different on certain things.
The following are the major different between return on equity and return on capital employed.
Objective: Equity Vs Capital Employed
The objective of assessing return on equity and return on capital employed is quite different. ROE intend to assess how the efficiently the equities are used and manage. Equity can be calculated by taking liabilities from assets. That mean all kind of liabilities are eliminated. However, ROCE is intended to assess how capital employed are manage and use in the entity. Normally, capital employed are bigger than equity if we use the same financial information. The main reason is capital employed include the long term liabilities. This is probably the big part that make this ratio different.
But, what are the reason behind this?
Well, basically the equity is the net worth of the entity but capital employed is the combination of net worth of entity plus long term liabilities. That mean ROE want to assess only the return to net worth, but ROCE want to know the return to net worth plus long term liabilities. These are the main reason why these two ratios use different profits figure.
Using of profits figure:
Another areas that make ROE different from ROCE is using of profit figure to calculate the ratio. ROE uses net profit for its calculation and ROCE uses profit before interest and tax for its calculation. As you could see, these both ratios use different types of profit for calculation.
But what are the reasons that these two ratio use different profits figure?
Well, let go back to the objective above. ROCE use profit before interest and tax because it want to assess the return on capital employed while this capital employed include long term liabilities.
Let see this formula,
Capital employed – long term liabilities = total equity
Profit before interest and tax – interest and tax = net profit.
So the major different here interest and tax in the profit figure and long term liabilities in capital employed.
Now we can use this,
(Interest and tax) / Long term liabilities
Therefore, these two ratios using different figure are because of the different of capital employed and equity.
To calculate return on equity, you first need to understand the two important things about it. First is the principle of return in equity, and second is the formula.
The principle basically refers to the way how important the return on equity is used to help investors and shareholders to assess the efficient shareholder’s equity are used or why should we assess this ratio.
The second important thing is how this ratio works. This will help investors and shareholders to analyze and interpret the ratio.
For example, what are the important items or factors that could affect the ratio?
Well, before we go to the calculation, let move the formula first.
The formula uses to calculate this ratio is quite simple.
Return on equity is calculated by dividing the net income for the period over its averages total equity. That means the two important things that directly affect the ratio is net income and averages total equity.
However, there are many items that could potentially affect the ratio. For example, financial policies whether the entity considers the high financial leverages or low, the costing strategy and well the production strategy that entity use to ensure the margin is high.
Now let move to the calculation of return on equity.
How to find the return on equity?
To find the return on equity, we need to understand the principle and formula. We already talk about this. Now let go directly to the example.
For example, ABC Company is the company that operates in clothes manufacturing and the net income for the period of 1 Jan 2015 to 31 Dec 2015 was 20 Million USD.
The averages total equity at the end of 31 December 2015 was 100 Million USD. Please find the return in the equity of ABC.
Here is the formula
Return on Equity is net income / total equity
- Net income = 20 Million USD
- Total equity = 100 Million USD
Return on equity is 0.2 or 20% (20/1000
What does it mean to shareholders of ABC by this ratio?
Well, as we mentioned above, the ROE is the ratio that helps investors and shareholders to assess how well the management of the entity uses the invested equity of shareholders.
In this calculation, the ratio is 20 times. That means in every dollar of equity in ABC, the entity could generate 20 Cents or 20% of it.
At this point, to let the ratio speak more meaningful, we should take this ratio compare to the previous period whether it is increased or decrease.
We could also compare it to the industry averages to see how good or bad the ratio is.
Some the investors or shareholders compare this ratio not only to the previous period, industry averages, but they also compare it to the competitors and well as the rate required by them.
Return on equity is the ratio that to use to measure the performance that an entity could generate over the period to its total shareholders’ equity. This ratio uses the bottom line of the entity over the period compared to averages total shareholders’ equity.
The good or bad ratio is depending on the requirement rate, previous period, and industry averages. A high ratio means high return, and a low ratio means less return.
In this article, we will talk about the five areas that we could use to five of our return on equity ratio.
The following is the formula that we will fix our ratio and it is very important to know not only how the ratio works, but also need to know how each item that we used are affected.
Formula = Net Income/ Shareholders’ Equity
The two important items in this formula are Net income and total shareholders’ equity or averages equity.
- Net income is basically the bottom line in the income statement, and before arriving this line, there are many items that we need to know. For example, sales revenues, cost of goods sold, gross profit, operating expenses, and other non-operating expenses like interest expenses, and tax. Net income is what the entity earned and will return to shareholders.
- Return on equity that use to calculate this ratio is including all equity items. And for easy to calculate, we can use the accounting equation to find out. That mean assets = liabilities + equity. Increase or decrease equity will also increase or decrease the ratio.
Now let see the five areas we could fix to increase or decrease return on equity ratio to the rate we need.
6 areas that you can use to increase or decrease ROE ratio:
1) Improve your financial leverage
Financial leverage is referred to as the entity’s policies on using the fund for its operation. Sometime the entity might use 50% debt and 50% equity fund. Or sometime, the entity might use other methods.
In some cases, the entity might prefer obtaining the debt to fund its operation rather than obtaining an equity fund.
In this case, total equities are small and the ratio will improve accordingly. However, we have to remember that using the loan to support operation, the entity will need to pay interest and principal back and it might face a cash flow problem.
The better the profit margin, the better net income and subsequently improve return to equity ratio. An increase in profit margin is very important for the ratio and it improves when the entity could improve production systems and well as costing system of the entity.
High productivity could lead to lower products cost and it will subsequently increase the margin. This margin could improve does not necessarily increase the number of sales unit, but it could improve by increased selling prices.
However, in the market where products are highly competitive, the entity could not increase the selling price.
The only room that they could improve is reducing costs by producing more products, buying low-cost material, hiring low labor costs.
3) Net profit margin
The increasing net profit margin will directly increase that return on equity ratio. And we can improve its base for two reasons. First, the gross profit margin is already improved.
That means if the gross profit margin improves and even the operating expenses remain the same, the net profit still improves. Second is improving net profit by improving operating expenses. Every single dollar of operating profit margin improve, do so net profit increase.
4) Improve asset turnover
Improve asset turn over could also help the entity to improve return on equity. For example, if the assets turn over is high that mean assets are effectively used or in other words, assets produce a good quantity of products with a high amount.
Improve assets turn over will improve both gross profit margin as well as net profit margin since the cost of products are low while the price could increase due to the quality of products.
5) Manage idle cash
Cash and cash flow management are quite important as it not only help an entity to solve its cash flow problem, but it also helps the entity to improve net income as well as reduce equity.
The entity could improve net income by pay off part or all of debt and then it will subsequently reduce the interest expenses. This will be a positive effect on net income and improve the ratio.
The entity could also use the idle cash to buy back some shares to that the equity will reduce and subsequently affect the ratio.
6) Tax expenses
Tax expenses are normally a large number of expenses in most of the entity and having the right strategy to reduce the tax expenses is quite important for the success of the entity.
There are many ways to reduce tax, for example, perform tax planning by making sure that the entity pays less tax but still compliance with tax law. This was normally done by hiring a tax consultant from professional firms.
The entity could also save tax expenses setting up the proper transfer pricing strategy as well as production diversity. For example, relocate the factory to the country where labor costs are low with a good tax incentive.
Above are the areas that you could use to improve your return on equity ratio. You could also use those areas to drop your return on equity if you need to.
Return on Equity (ROE) is one of the Financial Ratios that use to measure and assess the entity’s profitability based on the relationship between net profits over its averaged equity. Two main important elements of this ratio are Net Profits and Shareholders’ Equity.
Return on Equity (ROE) is the ratio that mostly concerns by shareholders, management teams, and investors in term of profitability assessment.
It is also commonly used as key financial indicators in performance measurement as well as setting as the KIP for the entity.
However, many accounting technical and investor warn that this ratio could return many risks to the entity if it is used improperly.
Return on Equity (ROE) is measuring the direct profits that the entity could possibly generate from business operations to its shareholders or investors over the invested fund (equity).
It is simply mean how much profit ($) the entity could generate per ($) invested.
The best way to make this ratio more meaningful is it needs to be used with other financial indicators as well as non-financial indicators. Return on Equity (ROE) is said to be good if it is over the cost of capital.
Return on Equity (ROE) = Net Profit / Total Equity
- The equity here is sometime could be the equity at the end of the period. and sometime it could be the equity on average. For fair assessment, the equity should be in averages. That means equity balance at the beginning of the period plus the equity balance at the end of the period divided by two. Yet, if you could not find or they provide only the equity at the end, let use the ending balance. You can also find the equity balance from the balance sheet if you don’t tell you. For example, total equity = total assets less total liabilities. Remember, equity is the net worth and none of the liabilities is included. It is different from capital employed since capital employed is net worth plus long term liabilities.
- The Net Income is quite straight forward. We just pick up the Net Income that you use for the period that you want to analysis. You can find net income in the income statement in the period you want to assess or calculate it from the balance sheet. However, the period that you analyst must be consistence otherwise your analysis will be not fairly interpreted. Remember, the net income that you use to calculate ROE must be after deduction of taxes and interest expenses.
The first thing that we need to think about in order to calculate and analyze Return on Equity (ROE) is Net Profit. Net Profit here is the profit after tax that entity generates for the period of time.
Net profit arrived after deduction many significant importance expenses. Those expenses are included Cost of Goods Sold, Operating Expenses, Interest Expenses as well as tax expenses.
As you could see the way how we calculate Net Income above. It is after deduction many significant expenses that could be manipulated by the entity if they wish to.
For example, depreciation expenses are subject to the entity’s accounting policies. Management could use both accounting technique and accounting policies to make depreciation expenses increase or decrease as they want to. And subsequently, affect Return on Equity Ratio.
The revenue also could be manipulated. For example, early recognition of Sales Revenue before the period that it should be. See the disadvantage for detail.
The second thing is Shareholder Equity. Shareholder Equity here include all equity items in the Financial Statements.
However, for fairness interpretation, Return on Equity, Average Shareholder Equity should be used. It is calculated by the average of both the beginning and ending of Shareholder Equity of an Entity.
Let do some fact check on the disadvantages of ROE,
- Return on Equity (ROE) is the profitability ratio that use by investors and shareholders to assess how profitable the company is compared to others, budget or expectation. That is the reason why this ratio create any kind of risks to shareholders whenever it becomes the first priority in performance measurement.
- The common reason why it is risky is that this ratio is the financial ratio (figure). The figure could be manipulated by the management. Management of the company needs to make sure it gets a better result. For example, if this ratio is used as the main key performance indicator for deciding management bonus. Then, management might try to play around with the figure.
- Management may try to manipulate the Return on Equity (ROE) by not investing the new fixed assets or do not make proper maintenance. It also keeps using the old assets that significantly affect the operating expenses through depreciation. This ratio also could be manipulated by using the depreciation rate that could be a positive effect Return on Equity (ROE). All of these will affect the future of the entity.
- Beside disadvantages, this Return on Equity (ROE) also has many advantages. It is easy to calculate and understand by most nonaccounting managers, investors, and shareholders. As we can see, this ratio is very easy to calculate. All of the information is available in the financial statements and it is calculated base on the logical basis. Non-accounting manager, investors, and shareholders are also able to confirm the accuracy of this ratio. Right?
- The basis is very easy to understand by most types of managers. The not only manager who has experiences in accounting could easily understand, but operation manager or division managers also easy to use and interpret.
- Most of the investors and shareholders are bench-marking the ROE from their own companies with the market figure or competitors. Especially, the one in the same industry. It provides them with a good starting point to assess their companies’ performance.
High Vs Low Return on Equity
Okay, let think about these questions
- Does Low Return on Equity really the problem?
- Is it always good if the return on equity is high?
Well, the answer is, it depends. Let us explain this.
As we explain above, the relationship between these ratios is mainly based on two important items. Net Income and Equity. And to increase this ratio, for sure we need to increase Net Income right? But what if the increase in net income is not because of the company performing well.
But because of management try to play around with some accounting policies to get income look better than what it should be?
Like the example above, sales revenue might be early recognized, depreciation policies implement inconsistently, using old assets to decrease depreciation expenses.
Another way to manipulate this ratio is to manipulate the equity items. How?
Well, what if management using external bank loans to buy back or pay the dividend to ensure that the equity balance decrease while the net income for that period is still the same.
Equity ratio will increase, right?
It is a big problem, right?
If investors depend on the return on the equity ratio solely when the consider whether to buy shares or having assessed that the entity is performing well.
So high ROE does not always mean good and low ratio does not always mean bad.
Deep analysis and comparison with other financial and non-financial ratios are seen to be the mandatory requirement to ensure that the wrong interpretation is being offered to investors.
Now, let start the example to get a better understanding of how to use the formula and calculation.
For example, ABC is the company operating in the bank industry. The shareholders are now real concern about the return on their shares capital that they invested.
Right now, the management team needs the ROE figure with analysis from your finance department.
For the period from 1 January to 31 December 2015, ABC generates USD 3,000,000 and the total equity at the end of the period is USD 70,000,000.
Use the formula above, there we got this:
Return on Equity (ROE) is 3,000,000 / 70,000,000 = 0.042 or 4.2%.
Now let see how figure tells us. Based on the calculation, ABC got 4.2% of its ROE and we don’t have the competitor ROE or IRR for ABC.
In general, to make a meaningful assessment, we should know previous year ROE, IRR, as well as the average ROE in the market ABC being operated.
What is a good return on equity?
It is a bit difficult to answer this question as it is very difficult to quantify the percentage that could satisfy the investors.
However, based on the nature of equity is high risks then debt, the higher return on equity compare to debt is considered the good one. For example, if the debenture interest rate is around 5%, then return on equity around 10% to 15% is quite good.
The good return on equity is also depending on the rate set by the Board of director, previous year rate, and industry rate.
Thanks for reading this article and if you think this article needs some improvement, please drop it below.
Written by Sinra