Difference Between ROIC and ROCE

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Synopsis:

Return on capital invested (ROIC) and return on capital employed (ROCE) are prominent financial ratios that are utilised to assess the profitability and capital efficiency of a company. In this article, we shall discuss the meaning and application of both ratios, how to calculate them, and the key points for ROIC vs ROCE.

One of the unifying themes across disciplines is performance analysis and its significance. Whether it is periodical exams at school or college or annual appraisals at work, analysis of past results has always been seen as an effective way to devise a course for the future. The same principle applies to companies as well, which is one of the reasons why periodical assessment of financial and operational performance is critical.

Financial ratios play an instrumental role in gauging a company's performance on various parameters, and two such ratios are return on capital employed (ROCE) and return on capital invested (ROIC). In this article, we shall discuss

  • What is ROIC and the formula for ROIC
  • What is ROCE and the formula for ROCE
  • How ROIC and ROCE can be interpreted
  • ROIC vs ROCE - major differences between the ratios

What is Return on Invested Capital (ROIC)?

Return on capital invested or ROIC is a financial ratio that reflects how well a company is utilising its actively invested capital to generate profits. Invested capital is the part of the total capital employed that is actually invested in the operations of the company. In the calculation of ROIC, the post tax earnings of a company are considered. Here is the formula for ROIC:

Return on capital invested = Net profit after tax / Capital invested

  • Net profit after tax = Earnings before Interest and Tax - Tax
  • Invested capital = Total share capital plus total debt

or

Invested capital = Total assets - (current liabilities + cash)

 

What is Return on Capital Employed (ROCE)?

Return on capital employed is a financial ratio that is used to measure the return generated on the total capital employed by a company. ROCE is considered an important barometer of the capital efficiency of a business as well as its profitability. In order to calculate return on capital employed, the following formula is used:

Return on capital employed = Earnings before Interest and Tax / Capital Employed

  • Earnings before Interest and Tax = Gross Profit - Operating Expenses
  • Capital Employed = Total assets - Current liabilities

Interpretation of ROIC and ROCE to gauge a company's profitability and capital efficiency

If the return on capital invested for a company is greater than zero, the company is said to be profitable and effectively utilising its actively invested capital. The higher the ROIC, the better. With regard to return on capital employed, if the ROCE value is higher than the cost of capital for a particular company, said company is considered to be profitable and making effective utilisation of its capital employed.

Key Differences Between Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE)

There are several similarities between return on capital invested and return on capital employed. Both the ratios indicate a company's degree of effectiveness in utilising its capital to generate profits. As such, both ROIC and ROCE are extremely useful for the internal as well as external stakeholders of the company. Since ROIC and ROCE use different variants of capital and profit, the ratios have certain differences in calculation as well as interpretation. The following table sheds light on the key differences between ROIC and ROCE:

ROIC vs ROCE - at a glance

Parameter

Return on Capital Invested (ROIC)

Return on Capital Employed (ROCE)

Variant of capital used

The formula for ROIC uses the capital invested in a particular business.

The formula for ROCE uses total capital employed in a particular business.

Scope

The scope of ROIC is narrower than that of ROCE, but it is seen as a more focused ratio.

ROCE has a wider scope that that of ROIC.

Variant of profit used

Net profit after tax is used in the calculation of ROIC.

Earnings before interest and tax are considered while computing ROCE.

Measure of profitability

A company is considered to be profitable is its ROIC is greater than one.

A company is said to be profitable if its ROCE is higher than the cost of capital.

Utility and relevance

ROIC uses post tax earnings to compute a company's capital efficiency and profitability. Therefore, it is highly useful for existing as well as prospective investors to gauge the present and the future profitability of the company.

ROCE uses Earnings before interest and tax to arrive at the profitability and capital efficiency of a business. As such, it is useful for the internal stakeholders of the company more so than external stakeholders.

Scope for comparison

ROIC can be used as a comparative metric only for companies existing in the same or relatively similar tax systems.

ROCE can be used to compare companies operating in varying tax regimes. However, owing to the differences in the capital structures of various companies, particularly across sector lines, such comparisons may not be highly feasible.

The Bottomline

ROIC and ROCE are effective metrics to assess the capital efficiency and profitability of a company. Both the ratios have widespread significance and find application amongst a wide array of stakeholders. 

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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