Fundamental analysis is a great technique that allows you to determine whether a company is financially sound and stable. It enables you to take investment decisions based on whether or not a company is fundamentally strong. Calculating and analyzing profitability ratios is one of the most popular ways to carry out fundamental analysis on companies.
More specifically, the Return on Capital Employed (ROCE) and Return on Invested Capital (ROIC) are two profitability ratios that can give you a good idea of the financial soundness of companies. Here’s everything that you should know about these ratios and the difference between them.
What is Return on Capital Employed (ROCE)?
Return on Capital Employed (ROCE) is a financial metric that helps you determine just how efficient a company is when it comes to generating revenue using the capital employed by it. A high ROCE figure is always favourable, since it indicates that a company is highly efficient at generating revenue and profits using the capital it employs.
With the following formula, you can easily calculate the Return on Capital Employed for a company.
|ROCE = Earnings before interest and tax (EBIT) ÷ capital employed|
Capital employed = shareholders’ equity + long-term debt liabilities
Capital employed = total assets – current liabilities
What is Return on Invested Capital (ROIC)?
Return on Invested Capital (ROIC) is another financial metric that measures just how well a company generates revenue using the invested capital. It allows investors to determine the prospective returns that they get to earn from their investments in a company. Similar to ROCE, a high ROIC figure signifies that a company is highly efficient at generating revenue using the funds invested by the company’s investors.
The formula used to calculate the Return on Invested Capital for a company is as follows.
|ROIC = net profit after tax ÷ invested capital|
Invested capital = fixed assets + intangible assets + current assets – current liabilities – cash
What is the difference between ROCE and ROIC?
Now that you’ve understood what ROCE and ROIC are, let’s take a look at the key differences between these two profitability ratios.
|Particulars||Return on Capital Employed (ROCE)||Return on Invested Capital (ROIC)|
|Metrics taken into account||ROCE takes into account the company’s operating income, i.e. earnings before interest and tax (EBIT).||ROIC takes into account the company’s overall net profit that remains after payment of all taxes and dividends.|
|Portion of capital considered||Return on Capital Employed considers all of the capital that a company employs in its business.
This includes shareholders’ equity and other long-term debt obligations such as loans and borrowings that a company would have availed to further its business.
ROCE also considers the capital used by the company for activities other than revenue generation as well.
|Return on Invested Capital considers only the capital that is invested and actively used by the company for production of goods and services.
That’s primarily why the ROIC only takes into consideration the fixed assets, intangible assets, and current assets of a company, since these represent the investments made by a company to generate revenue.
|Perspective||ROCE is an important profitability ratio that is used to take a look at things from the company’s perspective.
It is more useful for the company than an investor.
|ROIC, as a financial metric, is used to take a look at things from an investor’s perspective.
It is more useful for investors since it enables them to determine the prospective returns that they are likely to get from the capital they’ve invested.
|Metric indicated||Return on Capital Employed is a good indicator of the ability of the company’s management when it comes to generating revenue.||Return on Invested Capital is a good indicator of the productivity of the company’s operating assets.|
|Scope||Since ROCE considers all of the capital employed in a company, its scope is much broader than that of ROIC.||Since ROIC considers only a small subset of the capital employed by a company (invested capital), its scope is much more refined and precise than that of ROCE.|
Given all this, both ROCE and ROIC are two very important profitability ratios that are quite similar to each other despite the minor differences. That said, here’s a key point that you should note. These ratios hold good for companies with capital intensive business operations like manufacturing entities. The scope of ROCE and ROIC is quite limited with respect to service-based companies.