ROCE vs. ROI: An Overview
Return on capital employed (YEAR) and return on investment (ROI) are two profitability ratios that go beyond a company’s basic profit margins to provide a more detailed assessment of how successfully a company runs its business and returns value to investors.
In particular, both examine the company in terms of how efficiently it utilizes capital to operate, invest, and grow. ROCE and ROI, along with other evaluations, can be helpful to investors assessing a company’s current financial condition and its ability to generate future profits.
ROCE can only really be used when comparing companies within the same industry whereas ROI is more flexible and used to compare a variety of assets. ROI, however, does not take into consideration time periods.
- Return on capital employed (ROCE) and return on investment (ROI) are two profitability ratios that measure how well a company uses its capital.
- ROCE looks at earnings before interest and taxes (EBIT) compared to capital employed to determine how efficiently a firm uses capital to generate earnings.
- ROI compares the profits of an investment compared to the cost of the investment to determine gains.
- Both measures are similar in theory, however, ROCE looks at how capital is employed within a firm and is useful when comparing companies within an industry. ROI looks purely at the profit made on an investment.
ROCE examines how efficiently a company uses available capital with the following equation:
YEARS=Capital EmployedEBITwhere:EBIT=Earnings before interest and taxesCapital Employed=Total assets minus current liabilities
Capital employed is, in the simplest terms, the total amount of the firm’s assets minus current liabilities. It’s synonymous with available capital from net profits. The higher the value derived using the above formula, the more efficiently the company is utilizing its capital. It is critical that ROCE exceed the cost of capital (financing costs) or the company may be facing financial issues.
ROCE can be very useful for comparing the use of capital by different companies engaged in the same business, particularly in regard to capital-intensive industries such as energy companies, auto companies, and telecommunications firms.
For example, ABC Energy Co. generated $100 million in earnings before interest and taxes (EBIT) last year from its gas pipelines. The company has $750 million in total assets and current liabilities of $100 million. Its ROCE is 15.4%.
Meanwhile, XYZ Oil Drillers Inc. generated $400 million in EBIT with $4 billion in assets and $200 million in current liabilities. XYZ has a ROCE of 10.5% despite making more in EBIT and having an asset base that’s nearly five times that of ABC. In short, ABC is more efficient at making money with its capital.
ROI is a popular profit metric used to evaluate company investments and their financial consequences with respect to cash flow. The formula for ROI results in a percentage, and is calculated as follows:
ROI=Cost of InvestmentProfit from Investment×100
Any value greater than zero reflects net profitability, and higher values indicate a more effective use of capital investment. A negative value is considered to be a major warning sign of extremely poor capital management.
Many managers only choose investments that would generate a high ROI, which may not be the best decision when compared to investments with lower ROIs but that improve the value of the firm as a whole.
ROI can be utilized by companies internally to evaluate the profitability of production of one product versus another, in order to determine which product’s manufacturing and distribution represents the company’s most efficient use of capital.
Both measures help determine the efficiency of how well a company utilizes its capital. ROCE is a more specific return measure than ROI, but it’s only useful when used with companies within the same industry. The numbers used must also cover the same period.
Unlike ROCE, ROI is a bit more flexible, as it can be used to compare products, but also projects and various investment opportunities. The downfall of ROI is that it doesn’t take the factor of time into account.
An investment can have the same ROI and yet one can provide that return in a year, while another takes a decade. The ROI calculation also doesn’t take into account fees or taxes, which are important for a company’s bottom line.