My numb question is can ROCE be greater than ROE. By looking at the below formula I can say that ROE excludes the amount of debt with which the company operates while ROCE takes this into account.
Return on Capital Employed (ROCE) = Operating Profit / Capital Employed * 100
Return on Equity (ROE) = Profit After Tax / Net Worth * 100
If my understanding is correct than ROCE can never > ROE unless debt is negative. If that is correct than how come Persistent have ROCE 41 and ROE of 21.
Dupont of the ROE is as below
ROE = RNOA+FLEV(RNOA-NBC),
Where
RNOA = return on net operating assets/ return in invested capital
FLEV = Financial leverage
NBC = net borrowing cost after tax
The drivers for RNOA are operating margins known as the profitability measure and capital turnover known as the efficiency measure.Both of the values can be calculated as below
Operating margins = EBIT/Sales
Capital turnover = sales/invested capital
Product of the above two is the RNOA/ROIC, we also need to apply the tax rate to the final product to get the after tax ROIC.
Coming to the second part of the equation,
FLEV = NFO/Owner’s equity
Where
NFO = net financial obligations, calculated as financial assets - financial liabilities. The ratio implies that for every 1 Re of equity how much is the leverage that the company has. Higher the number more the leverage than the company has.
RNOA - NBC = Operating spread, leverage works only when this spread is positive, that is the company makes more than its after tax borrowing costs. If this spread is negative then leverage will not work for the company.
There may be two cases when the ROCE/ROIC may be greater than the ROE, they are as below
The operating spread is negative, company borrowing costs are higher than the return on operating assets and the ROE goes down.
The company has net financial assets, that is financial assets are greater than the financial obligations. The calculation of ROE in this case is as below
ROE = RNOA-(NFA/owner’s equity*(RNOA-RNFA) where
NFA is net financial assets
RNFA is return on net financial assets calculated as net income/financial assets
Positive spread between the RNOA-RNFA reduces the ROE because funds of the company have been invested in financial assets which earn less than the RNOA and hence this drags down the overall ROE.
My 2 cents,
While checking the ROE/ROCE , ROCE is need to give more importance because ROE could be increased by increasing Financial Leverage ,
As per DUPONT Analysis,
ROE = Net Profit margin * Asset Turn Over ratio * Leverage (Individually each parameter indicates how company is managing expenses, Asset and Debt.)
= (Net Profit/Sales) *( Sales/Assets) * (Assets/Equity)
If We further broken down NPM then we got
= (Net Profit/PBT ) * ( PBT/PBIT) * (PBIT/Sales) * ( Sales/Assets) * (Assets/Equity)
= Income tax Burden * Interest Burden * OPM * Asset TurnOver * Financial leverage
Hence ROE could be increased by use of leverage which is not good. So along with ROE, NPM should be also checked because it will tell about the Interest burden.
ROCE (EBIT/Capital Employed) is very important parameter because it tells How company smartly generating profit from the funds.The denominator
Capital Employed = Fixed Asset + Working Capital
where Working Capital = Current Asset - Current Liability.
So Capital Employed = Fixed Asset + Current Asset - Current Liability.
Now if company’s Fixed Asset is low (i.e company’s business model is Asset Light) and If company have good bargaining power , Pricing Power the working capital will be less even negative , then it will have very High ROCE.
Company who enjoys bargaining power , pricing power , good brand they have very less Working capital because Trade payable (part of current liability) often higher than trade receivable(part of current asset). These companies also generates lots of positive operating cash
I always find it a better approach to start from fundamentals than to go the ratio analysis way
ROCE = EBIT/Capital Employed
Capital Employed = Fixed capital + Average working Capital
Working Capital = Current assets - non interest bearing current liabilities
WC depends on the inventory, receivables and payables
Consider the following scenario -
Two companies operating in the same segment will often be selling similar product portfolio to similar customers and in turn procuring raw material from similar suppliers. Unless the product portfolio is drastically different they will end up having similar inventory, AR and AP terms. They will more often than not employ similar technology to produce their products/services, which in turn means the fixed asset turns will run a similar range once again. Similar level of fixed capital means depreciation will once again be in the same range
Hence ROCE for these two companies will be in the same range however ROE can be drastically different based on the capital structure
I find it easier to slice and dice a business based on ROCE since it forces me to ask the questions of what is the firm doing differently from competition?
If firm A has superior ROCE than firm B which is operating in a similar segment, what is the source of this superiority in capital efficiency?
Is it relative scale which allows better purchasing terms and lower logistics cost per unit?
Is it better technology which allows for higher asset turns in the long run?
Is it a better brand which allows for pricing power?
Does firm A have a particular product/offering where it is able to get better terms from customers? If so is this pocket expected to grow faster in the coming years?
How is the product portfolio evolving over time? Is management allocating capital to the products which will take ROCE higher from here?
as opposed to ROE which is focuses too much on the PAT number It is easier to show a spike in ROE (by say lower taxes) than in ROCE, ROCE is the real deal
Though it’s easier to use the formula Capital Employed = Equity + Debt, there are some cases like so much of capital is locked in CWIP (capital work in progress) in such cases above formula didn’t give correct values of CE and hence the ROCE.
How Relavent RoCE is for Financial institutions ( Banks , NBFC ) etc ?
I understand it’s key for capex intensive businesses like power/mining / Oil & Gas etc.
Not sure how important or Relavent RoCE is when it comes to financial firms for whom capital is raw material.
