Returns are the lifeblood of any financial endeavor, whether it’s personal finance or running a business. They represent the gains or losses generated from investments or operations over a specific period. In personal finance, returns are essential to measure the performance of investments, savings, and overall financial well-being. For businesses, returns play a crucial role in the Profit and Loss (PnL) statement, indicating how effectively the capital invested is being utilized to generate profits. Analyzing and understanding returns can provide valuable insights into the effectiveness of financial decisions and the potential for growth.
Return on Equity (ROE)
In personal finance, when you book a Fixed Deposit, you expect returns, which are measured as a percentage of the capital deployed. In India, it could range from 5-8%, depending on the economic circumstances. Similarly, companies also invest shareholders’ money into the business, which is called Equity Capital or Shareholders’ Capital, and this is expected to generate returns for the shareholders. This is called Return on Equity (ROE). If the company is generating a lesser ROE than the FD rates, then it simply means that even without running the business, had they just booked that money as an FD, they could have achieved better returns. On the other hand, the company is running a healthy business if the ROE is way beyond the prevailing FD rates.
ROE = Profit After Tax ( PAT) /Equity
(or) ROE = Earnings Per Share (EPS)/ Book Value Per Share (BVPS)
This metric is particularly vital for shareholders and investors as it indicates the company’s ability to reward them with significant returns on their investments.
Return on Capital Employed (ROCE)
If you find an opportunity where you can get a loan at 2% interest, and there is a bank that gives you 5% interest on a Fixed Deposit, wouldn’t you grab this opportunity? This is called Arbitrage, and there are companies who have mastered this and take debt to run the company, in addition to the equity funds from the shareholders. In such scenarios, apart from ROE, an important measure to check is whether the company is generating more money from the capital deployed to pay interest and still retaining some earnings or not. This measure is called Return on Capital Employed (ROCE).
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
(or) ROCE = Earnings Before Interest and Tax (EBIT) / Equity + Debt
ROCE is crucial because it assesses how efficiently a company uses all available capital to generate profits, including both its own and borrowed funds. It is an essential metric for business owners and management as it highlights the company’s operational efficiency and overall financial health.
Typical Values of ROE and ROCE
Typical values of ROE and ROCE can vary significantly across different industries.
Industries with high capital requirements, such as manufacturing or infrastructure, may generally have lower ROE figures due to significant investments in assets. On the other hand, industries that rely heavily on intangible assets, like technology companies, tend to have higher ROEs. A good ROE value varies depending on the company’s size, industry norms, and its growth stage.
As for ROCE, a figure higher than the company’s borrowing costs suggests efficient utilization of capital, while a value lower than the borrowing costs may indicate ineffective capital deployment.
Taking TCS India as Example.
PAT and EBIT can be found in the PnL Statement , Equity and Debt could be found in the Balance Sheet and below is a simple Example .
Financial Summary of TCS can be found here and we could consider for FY 22-23
| Parameter | Value ( in Crores) |
| PAT | 42303 |
| EBIT | 59259 |
| Equity | 366+90058 = 90424 |
| Debt | 7688 |
| ROE = PAT / EQUITY | 46% |
| ROCE = EBIT / Debt + Equity | 60% |
Summary
Both ROE and ROCE are essential financial metrics that provide valuable insights into a company’s performance and efficiency. ROE mainly focuses on the returns generated from shareholders’ investments, making it crucial for investors and shareholders. ROCE, on the other hand, takes a broader view by considering all capital employed, making it more relevant for business owners and management. While ROE is essential for assessing shareholder value, ROCE helps gauge the overall operational efficiency and profitability of a company. Ultimately, understanding both metrics and their implications can empower individuals and businesses to make informed financial decisions and drive sustainable growth.
Here’s the Comprehensive List of Our Blogs: Keep it Handy, Share with Friends and Family, Smash that Like Button, and Subscribe to Receive Blog Updates First. Your support fuels our passion for creating insightful content!
Disclaimer: This blog post is intended for informational purposes only and should not be considered as financial advice. Always conduct thorough research and consult with a qualified financial professional before making investment decision.