Difference Between ROIC and ROCE

Key Difference – ROIC vs ROCE
 

ROIC (Return on Invested Capital) and ROCE (Return On Capital Employed) are two essential ratios calculated for the financial year end. These two measures are largely similar in nature with limited differences. The key difference between ROIC and ROCE mainly lies in the way they are calculated; ROIC measures the efficiency of total capital invested, while ROCE is a measure to inspect the efficiency of business operations.

CONTENTS
1. Overview and Key Difference
2. What is ROIC
3. What is ROCE
4. Side by Side Comparison – ROIC vs ROCE
5. Summary

What is ROIC?

ROIC (Return on Invested Capital) is a measure that assesses the company’s ability to allocate capital into profitable investments. In other words, this indicates how well the business is using funds to generate income. ROIC is calculated as below.

ROIC = (Net income – Dividends) / Capital Employed

• Net income – total earnings for the financial year
• Dividends – sum of funds paid to shareholders out of profits
• Capital Employed – the addition of debt and equity and an average amount is considered as (Opening capital + Closing capital) /2.
• Debt – funds borrowed on credit
• Equity – capital contributed by shareholders

For ROIC to be useful, it should be compared with the weighted average cost of capital (WACC). If ROIC exceeds WACC, this is an indication that the company has created value during the financial year.

Weighted Average Cost of Capital (WACC)

This is a calculation of the company’s cost of capital by considering each category’s contribution on a proportionate basis.

E.g. If company’s capital consists of debt and equity, WACC calculates,

• What is the cost of equity as a proportion of total capital?
• What is the cost of debt as a proportion of total capital?

WACC is an important measure that calculates the average cost of capital the company has to pay for its capital contributors. This is the minimum rate of return the company should earn in order to create value for its shareholders.  The difference between ROIC and WACC is sometimes referred to as a firm’s ‘excess return’ or economic profit.

Since net income is the total earnings, this is calculated after gains and losses of all business activities. However, one-off transactions that earn a profit or loss (e.g. gain or loss from foreign currency fluctuations) reduces the accuracy of ROIC since they are not related to normal business operations. Thus, it is more effective to get the income generated through core business activities rather than the actual net income amount in the income statement. ROIC is an average measure thus this does not show the performance and value generation by individual assets or business segments.

What is ROCE?

ROCE (Return on Capital Employed) is the measure that calculates how much profit the company generates with its capital employed. Therefore, ROCE becomes both a profitability and efficiency ratio. ROCE is calculated as,

ROCE = Earnings Before Interest and Tax / Capital Employed

Higher the ROCE, the more efficient the manner that capital is been utilized by the company. It is also important for companies to maintain an increasing ROCE over the years to ensure an upward trend since this demonstrates that the business is stable and investors see them as attractive investment options. Similar to ROIC, this measure is also an overall one that does not provide a detailed value generating information of individual assets.

Figure_1: ROIC and ROCE are more effective when used by capital intensive industries.

What is the difference between ROIC and ROCE?

Summary – ROIC vs ROCE

ROIC and ROCE are both key ratios that allow comparisons between companies and past year ratios. ROIC measures the efficiency of total capital invested, while ROCE measures the efficiency of business operations. They are much suited for companies in capital-intensive industries such as telecommunication, energy and automotive.  These measures have limited use in service related companies.

Reference:
1. “Return On Invested Capital – ROIC.” Investopedia. N.p., 24 Aug. 2015. Web. 13 Feb. 2017.
2.”Weighted Average Cost Of Capital – WACC.” Investopedia. N.p., 29 Sept. 2015. Web. 12 Feb. 2017.
3.”Return On Capital Employed (ROCE).” Investopedia. N.p., 30 Sept. 2015. Web. 13 Feb. 2017.

Image Courtesy:
1.“Final assembly 2” By Brian Snelson – originally posted to Flickr as Final assembly (CC BY 2.0) via Commons Wikimedia

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