Return on equity and return on capital employed ratios are profitability ratios used by management, investors, and shareholders to assess how an entity uses 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 equity averages or equity at the end of the period.
On the other hand, return on capital employed use profit before interest and tax for the period and capital employed. Although these two ratios are used to assess an entity’s profitability, they both are different on certain things.
The following are the significant differences 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 intends to assess how efficiently the equities are used and manage.
Equity can be calculated by taking liabilities from assets. That means all kind of liabilities is eliminated. However, ROCE is intended to assess how capital employed is managed and use in the entity.
Normally, capital employed is bigger than equity if we use the same financial information. The main reason is capital employed includes long-term liabilities. This is probably the big part that makes 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 the net worth of the entity plus long-term liabilities.
That means ROE wants to assess only the return to net worth, but ROCE wants to know the return to net worth plus long-term liabilities. These are the main reason why these two ratios use different profits figures.
Using of profits figure:
Another area that makes ROE different from ROCE is using profit figures 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, both ratios use different types of profit for calculation.
But what are the reasons that these two ratios use different profits figures?
Well, let go back to the objective above. ROCE uses profit before interest and tax because it wants to assess the return on capital employed while this capital employed includes 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 difference here is 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 figures are because of the difference of capital employed and equity.