**Return on capital is arguably the most important indicator of the** **inherent economics of the business. In this post, we explore the nuances in analyzing the return ratios.**

While analyzing a business, you may look at different ratios such as profitability, growth, gearing/leverage, cash conversion cycle, etc. All of them serve different purposes but only return ratios help us figure out if the business is investible. For example, profitability ratios tell us what a business earns relative to the revenue it generates but it doesn't tell us how much capital is utilized to generate those revenues and earnings. Return ratios not only provide a sense of the earnings power but also how efficiently the capital was utilized in the business. Let's delve into how different return ratios are calculated and important considerations in analyzing them.

**What are return ratios**?

**Return on Equity (RoE)**

**RoE ****=**** Profit after tax ****/**** Shareholders' funds**

RoE means the rate of return on equity shareholders' funds. Equity shareholders' funds include equity share capital as well as general reserves and surplus available to the shareholders. Return on equity reflects how efficiently the business has utilized shareholders' funds. High RoE usually indicates good managerial performance and attractive fundamentals of the business.

But what do we consider as high RoE?

This is a difficult question and it often depends on the sector in which the firm operates. That said, 15-20% is decent, 20-25% is high and more than 25% is excellent in the Indian context. It is believed that in the long term, returns from investment in a stock converge with the long-term returns on equity generated by the business.

**Return on Capital Employed (RoCE)**

**RoCE ****=**** Earnings Before Interest ****&**** Taxes ****/**** Capital employed **

RoCE means the rate of return on overall capital employed. Capital employed includes shareholders' funds as well as long-term debt. This ratio considers operating profit before interest and tax (EBIT) in the numerator instead of net profit as we have a debt component also in the denominator. **In that sense, RoCE is a broader and more** **reliable indicator of capital efficiency as compared to RoE**. We will explore its utility later in the post.

**Return on Invested Capital (RoIC)**

**RoIC ****=**** Net Operating Profit After ****Tax**** ****(****NOPAT****)**** ****/**** Invested capital **

This is the most interesting return ratio mainly because it's the most conservative one. It uses invested capital in the denominator which is nothing but capital employed less cash and cash equivalents. NOPAT is EBIT * (1- Tax%).

Capital employed can be considered as equity plus long-term debt but if we consider the asset side, invested capital is represented by fixed assets and working capital. If the firm has more cash and cash equivalents and non-operating assets on the balance sheet, then there can be notable divergences between RoCE and RoIC. Nevertheless, RoIC measures the efficiency of the assets actually invested in core operations and is hence widely used by analysts and investors.

**Return on Assets (RoA)**

**RoA ****=**** Profit after tax ****/**** total assets**

Return on assets means the rate of return on total assets. In other return ratios discussed above, we have considered a portion of the balance sheet whereas, in RoA, we are considering total assets including non-operating assets and cash. This ratio measures how efficiently the overall assets of the business are utilized. A version of this ratio considers return on fixed assets instead of total assets.

## We prefer higher returns on capital. But why?

Capital is scarce and it entails opportunity costs. Thus business needs to generate returns more than the cost of capital invested in it. If it's not the case, then the long-term survival of the business is difficult. Because the cash flows will not be sufficient to service the capital providers. Only excess returns over the cost of capital allow firms to generate free cash flows which is a defining characteristic of durable businesses.

Having said that, the cost of capital is difficult to measure. This is especially true for equity than debt. We will not discuss the formula for calculating the cost of capital but conceptually it is the minimum hurdle rate of return that a business needs to generate to survive. Since it's difficult to calculate the cost of capital precisely, we prefer RoE and RoCE of more than 15% considering some buffer.

## Returns can be further investigated

Remember that *Du-pont* formula for calculating RoE? It basically breakdowns the returns on equity into three components. Profitability, asset efficiency, and leverage.

*Du-pont* analysis provides us with important clues on where the returns are coming from. RoE stemming from high profitability or efficiency or both is preferable. However, high RoE becomes misleading if the leverage multiplier is the major component among all three.

Furthermore, consistency in RoE trends is preferable. Occasional spurts in RoE might occur because of the temporary upcycle, one-off gains, or high leverage. Consistently high returns backed by profitability and efficiency indicate management excellence and the presence of inherent competitive advantages in the business.

## RoCE has got a leg up on RoE

RoE should not be evaluated in a vacuum and it should be evaluated with RoCE and other indicators. This is so because RoE can be artificially inflated by the management with the use of a leverage component. **However, RoCE considers both equity and debt in the denominator which makes the ratio capital structure neutral.** Simply put, it can't be manipulated with leverage. Let's illustrate this with the help of different scenarios. For ease of reference, everything else is assumed to be constant.

**Scenario 1: No debt - RoE is at 7.2% and RoCE is at 9.6%**

**Scenario 2: 30% debt with 5% interest cost. RoE is at 8.7% but RoCE is at the same level. **

**Scenario 3: 70% debt with 5% interest cost. RoE zooms to 15.1% but RoCE is still the same.**

Out of the above three scenarios, the second one is preferable. Big divergences between RoE and RoCE such as illustrated in scenario 3 are not good and points at potential manipulation of RoE.

In the above scenarios, debt is taken at 5% annual interest cost which is less than returns on assets. Let's examine the final case where debt is available at a cost more or less equal to the returns on assets.

**Scenario 4: 30% debt with 10% interest cost. RoE and RoCE both remain at the same level.**

You see, both RoE and RoCE are at similar levels as scenario 1. This means that the cost at which the debt is taken should be less than the returns generated from assets to benefit from the leverage multiplier component. That concludes our discussion on return ratios.