Which is better: ROE or ROCE?

Return on equity (ROE) is a commonly used metric for comparing companies. It's relatively straightforward and is calculated by dividing the net income by total equity. On the other hand, return on capital employed (ROCE) is calculated by dividing the operating profit after taxes by the capital employed. Capital employed is the sum of fixed assets (factories, machines, buildings, etc.) and working capital (inventories, accounts receivable, etc.).

Both ratios are used for understanding the efficiency of a company's operations relative to the quantum of capital employed. While ROE uses the overall accounting profits in relation to shareholders' funds (net income and total equity), ROCE is considered a superior measure due to its focus on operating profits and overall assets, both debt and equity. This makes ROCE especially useful for assessing the efficiency of those companies where debt is an important part of the capital structure.

While ROCE can be used for most sectors, it's not appropriate for finance companies, given that their business itself is based on leverage. For them, return on assets (ROA) would be a better metric. ROE, however, can be used for any company. But it cannot be used when a company doesn't make profits.

Case in point: Chambal Fertilisers
Chambal Fertilisers & Chemicals' ROE of 38.1 per cent (as of FY20) may look impressive. However, its ROCE stands at a much lower 14.38 per cent. The company's debt-to-equity is 2.85. Thus, debt forms a major part of the company's capital structure. Looking at Chambal's ROE alone would be misleading.

Also in the series:

Look at the EPS, not just profits

Net profits can be misleading