ROCE vs. ROA: What’s the Difference?

Return on Capital Employed (ROCE) vs. Return on Assets (ROA): an Overview

Profitability ratios are used to determine whether companies can earn profits based on the information presented in their financial statements. Investors can use this information to make important decisions about their investments by comparing the ratios of different companies. Two of these ratios include return on capital employed (ROCE) and return on assets (ROA). The ROCE ratio is a metric that evaluates how efficiently a company’s available capital is utilized while the ROA measures a company’s profitability relative to its assets.

Key Takeaways

• Return on capital employed and return on assets are profitability ratios.
• ROCE measures profitability relative to a company’s employed capital.
• ROCE is best used to compare companies in capital-intensive sectors, such as those that carry a lot of debt.
• Return on assets is a profitability ratio that focuses on the efficient use of assets.
• These profitability ratios are best used to compare similar companies in the same industry.

Return on Capital Employed (ROCE)

Return on capital employed is just one profitability ratio that financial managers, stakeholders, and investors can use to make decisions about potential investment opportunities. This financial ratio assesses a company’s profitability and capital efficiency. As such, investors and analysts can use it to determine how profitable a company is based on how well its working capital is used.

ROCE is expressed as a percentage and indicates the amount of profit a company generates for every $1 of capital it employs. Higher profits per dollar are better for the company and its investors. A company with a high ROCE means it has a high degree of profitability. A good ROCE ratio for a company should always be higher than its average financing interest rate.

This ratio is best used when comparing companies in capital-intensive sectors, such as utilities and telecoms, because, unlike other fundamentals, ROCE considers debt and other liabilities as well. The ROCE is useful for comparing companies with significant debt.

ROCE may need adjustments, including subtracting cash from capital employed, to get a more accurate measure for comparison. The long-term ROCE is important, where investors favor companies with stable and rising ROCE numbers.

How to Calculate ROCE

The formula to calculate ROCE is as follows:

$begin{aligned} &text{ROCE} = frac{text{EBIT}}{text{Capital Employed}}\ &textbf{where:}\ &text{EBIT} = text{Earnings before interest and tax} end{aligned}$​ROCE=Capital EmployedEBIT​where:EBIT=Earnings before interest and tax​

Capital employed is defined as total assets minus current liabilities or total shareholders’ equity plus debt liabilities. Therefore, it is similar to the return on equity (ROE) ratio, except it also includes debt liabilities.

Note

The higher the ROCE, the more efficiently a company makes use of its available capital to generate profits.

Return on Assets (ROA)

The return on assets measures the profitability and financial efficiency of companies. The difference between ROA and ROCE, though, is that the ROA ratio focuses on how profitable a company is relative to its assets. More specifically, this ratio determines whether a company can earn profits based on how efficiently it uses its assets.

ROA is commonly expressed as a percentage. A high ROA is a strong indication that a company is functioning well and making significant returns from assets. Conversely, a lower percentage could signal that the company is in trouble and needs to make improvements.

A return on asset ratio of over 5% is generally considered good while a ratio of 20% is deemed excellent. Having said that it’s important to take this information with a grain of salt. That’s because different industries report assets differently. For instance, there are fewer assets on the balance sheets of software companies, and they may be understated. This means that you may end up with slightly skewed results.

How to Calculate ROA

ROA can be calculated using the following equation:

$text{ROA} = frac{text{Net Income}}{text{Total Assets}}$ROA=Total AssetsNet Income​

The ROA ratio divides a company’s net income (or its annual earnings) by total assets to indicate how much revenue per dollar is generated related to the company’s assets.

Make sure you compare the ROA of similar companies within the same industry. Comparing companies from different sectors won’t give you an accurate baseline for your analysis.

Key Differences

The differences between the ROCE and ROA ratios are not many, but they are significant. Different profitability ratios exist precisely to enable investors and analysts to evaluate a company’s operational efficiency from various perspectives to obtain a fuller picture of a company’s true value, financial condition, and growth prospects.

We’ve highlighted some of the key differences between these two ratios in the table below.

What Are Some of the Most Important Profitability Ratios?

Some of the most important profitability ratios that investors should look out for include:

• Gross profit margin
• Operating profit margin
• Return on assets
• Return on equity
• Return on invested capital

Why Should Investors Pay Attention to Profitability Ratios?

Profitability ratios allow investors to make better, well-informed decisions about their investments. That’s because they can indicate whether a company is financially successful and is poised for future growth. When a company is profitable, it can provide positive returns and minimize losses to an investor’s portfolio. Low ratios can indicate that a company may be in trouble. These ratios can be used to analyze similar companies within a sector to see how well they are competing and managing their assets.

What Is Return on Equity?

Return on equity is a financial metric used to determine a company’s profitability based on how easily it can convert its equity financing into profits. This ratio is calculated by dividing a company’s net income by its total shareholders’ equity and multiplied by 100. As such, this metric is expressed as a percentage. Whether a company’s ROE is good or bad (or high or low) depends entirely on the peers in its sector.

The Bottom Line

Profitability ratios can help you make important decisions about your investments. Two of these are the return on capital employed and return on assets. While ROCE can tell you how well a company is using its capital, return on assets indicates a company’s profitability based on the use of its assets. One thing to keep in mind is that you compare ratios of similar companies within the same sector. And be sure to make your decisions using different metrics so you get a better picture of how well your potential investors will fare.