Return ratios is one of the most important part of analysis for an investor. These ratios are very important because if not analysed properly then the whole analysis can go wrong. So here in this article we are going to understand 4 main return ratios:
- Return on Equity (ROE)
- Return of capital employed (ROCE).
- Return on invested capital (ROIC), &
- Return on incremental invested capital (ROIIC).
Let us start with the first ratio called Return on equity (ROE):
Return on Equity= Net income (PAT)/ Total equity.
The return generated by the firm on the shareholder’s equity is known as return on equity. This ratio is majorly used for the companies which has major equity component and less debt component. We don’t use this ratio on leveraged companies as taking leverage amplifies ROE because in numerator we are taking earnings of whole company but in denominator we only taking equity capital and are avoiding debt. To understand what factors drives ROE movement now we will see DuPont ROE.
Return on equity (DuPont)
DuPont was an accounting firm that came up with this breakup of ROE. This formula tells us what are the factors that are driving ROE.
What is the relation between these components and how is it related to ROE?
Asset/Equity (Financial leverage)* Revenue/Asset (Asset turnover)* PAT/Revenue (Net profit margin)
- ASSET/EQUITY = Asset can be bought either by debt or by equity. This ratio shows on how much equity we got our assets.
- REVENUE/ASSET = As we got our assets, those assets will generate revenue for the company. This ratio shows how much revenue will the company generate with the help of their assets.
- PAT/REVENUE = As the company will generate revenue it will also make some margins known as net profit. This ratio shows how much net profit is generated on total revenue.
This activity shows the running of the business. And if we combine all these things together it looks like how much money did we used to buy that asset (Equity). After buying that asset what was the revenue which was generated from that money (Equity) and at last what is our profit margin on that so (this is the long way of calculating return on our money) but if we multiply this ratio Asset and revenue cuts each other so the final formula came out of ROE was PAT/EQUITY.
As stated above increase in any of the three components (1) Net profit margin 2) Asset turnover and 3) Financial leverage) would lead to increase in ROE ratio. Now let us understand when increase in ROE is good for a business by taking examples:
What do you think which company will quote at premium in the market?
Although ROE of Company B is higher but Company A will get more premium than Company B. There is a simple reason why company A would get premium is 1) Net profit margin of company A is higher and 2) Although ROE of Company B is higher but it is because of Leverage ratio. Let us take another example to understand a point what are the mistakes we shouldn’t do when looking at ROE:
So what the main thing to learn here is:
- ROE increasing due to Net profit margin and Asset turnover would get premium in the market.
- Whenever we are looking at ROE then we should look at DuPont ROE because this tells you the source why ROE is increasing.
Limitation of ROE is:
- More the leverage with the company More the ROE of the company because in numerator we are taking earnings of whole company but in denominator we only taking equity capital and avoiding debt. This is why leverage amplifies ROE ratio. To cater this limitation we can use ROCE.
Return on capital employed (ROCE):
The return which the company has generated for all the stakeholders of the company is known as return on capital employed.
In ROCE we assume our debt as our equity and calculate return accordingly. In this ratio we have taken EBIT*(1- Tax) (Earnings before interest and taxes) in numerator as it doesn’t get affected by company’s capital structure as interest and taxes are yet to be deducted. As we assumed debt component as equity component so we don’t have to pay interest for that but instead of interest we have to pay tax on that portion. This is why we have taken EBIT*(1- Tax) in numerator. In denominator we have taken Total capital of the company which is debt + Equity. Debt= Long term debt + Short term debt + Current portion of long term debt and Equity= Share capital + Reserves and surplus. We have taken Total capital to remove the effect of leverage. This ratio shows the return on the total capital which got invested in the company no matter in what form (debt or equity). Along with this ROCE use Cash ROCE formula which tells you how much return your company made on cash basis so by comparing Cash ROCE with ROCE ratio you can understand that how much your company is earning on cash basis:
This ratio (ROCE) although removes effect of leverage but there is a built-in assumption here which is every penny invested in company is used to generate operating revenue which contributes to PAT. But this is not always true as there might be presence of Non-operating investment and Non operating revenue in the company. So to remove this limitation there is another ratio named Return on invested capital (ROIC).
Return on Invested capital (ROIC):
This ratio tells you “how much return your core-business has generated”. ROCE is total return (Business + Investment) of the firm. So in this ratio we have to deduct Return generated through investment and the capital employed other than core business activities. This ratio is improvisation of ROCE as this ratio shows you the actual return of your business and main thing things is there in no impact of leverage in this ratio too.
We have deducted all the non-operating revenue and investment from the formula (revenue from Numerator and Investment from denominator as that doesn’t helps in generating operating income). Working capital= Debtors + Inventory – Advances from customers – payables. Core assets will vary as per industry.
When to use this Ratio?
This ratio tells you the actual return generated from the core activities. In this ratio we don’t include investment although company is earning from that because the main business of that company is not to make investment and make return from securities. It’s main job is to manufacture goods (if manufacturing company). ROCE and ROIC can differ due to investments. ROIC might come higher than ROCE in case company has made loss in investment so it’s better to view both the ratio.
Return on Incremental Invested Capital (ROIIC):
Returns generated from the incremental/ additional capital from the business. Company can invest additional capital in the same line of business in which it operates or company can invest that capital in different segment all together depends on the company.
There is one limitation of ROIC which is it doesn’t show the trend it always shows you the final result which means:
In the above image you can see average of both companies are coming same but are they actually same? The clear answer is no so by using ROIIC you get to know the return generated by the incremental capital invested. In initial years ROIC of that firm will come down because the new plant wouldn’t have been operating at maximum capacity. Now let’s imagine company has moved to different segment instead of investing in current segment then what will happen? Now for this type of company it’s very important to find ROIIC because if that company has gone in a segment which has return lower than their current ROIC then Company’s ROIC will fall in the coming years.
Main difference to Remember in ROIIC is timing of CAPEX V/s Wrong allocation of capital:
This means you need to know what factor is driving that number for example Company A did CAPEX into new segment in 2019 by setting up the factory. That plant wouldn’t be contributing in revenue till now (due to COVID-19) so that’s called wrong timing not wrong CAPEX.
Conclusion:
- Each ratio has it’s own utility and importance.
- ROE doesn’t take into account leverage. That’s why ROCE is improvised version of it which removes the effect of leverage.
- ROCE removes leverage but it has a built-in assumption that each penny is invested in operating assets and contributes to operating income. So we use ROIC instead of ROCE.
- ROIC removes both the above limitation which ROE and ROCE has and is improvised version of ROCE.
- ROIIC tells you the return on the incremental capital you invest which which ROIC doesn’t tell you.
- Every ratio is as important but we should know that which ratio is used when and what are it’s limitations so that we can make sense out of numbers.
PFA excel file in which we have done this ratio analysis of specialty chemical companies.
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