Return on equity (ROE), return on assets (ROA), return on invested capital (ROIC), and return on capital employed (ROCE) are four ratios that are commonly used to determine a business's ability to generate returns on its capital.

Investors should understand the difference between all four, including the pros and cons of each.

Return on Equity (ROE)

Formula: ROE = Net income/Total equity

ROE is calculated by dividing net income by shareholder equity (the average amount of equity investors have put into a company over a set period).

Why it matters: This formula tells us how efficiently a company generates profits. The higher the ROE, the better the business converts equity into profits.

Investor beware: It should also be noted that if a company buys back a lot of shares, its ROE will appear unusually high. That’s because the repurchasing activity lowers the equity. Of course, buying back stock can be a great way to reward shareholders, but it can warp the ROE calculation.

Return on Assets (ROA)

Formula: ROA = Net income/Total assets

ROA is calculated by dividing a company’s net operating profit after tax (NOPAT) or net income by total assets on the balance sheet. Assets are any item of property owned by the company that has value. They are found on the balance sheet.

Why it matters: This formula tells investors whether a company efficiently uses its assets to generate profits. It also factors a company’s debt, which ROE fails to do.

Investor beware: ROA includes depreciation, so it will often be lower for capital-intensive businesses. It can also be misleading for newer companies with non-earning assets.

Return on Invested Capital (ROIC)

Formula: ROIC = NOPAT/Invested Capital

ROIC is found by dividing NOPAT by invested capital. NOPAT is a company’s income after taking out debt expenses (e.g., paying interest) and interest income. Invested capital is the total debt and issued equity of a company.

Why it matters: This ratio measures how effectively a company deploys capital in profitable ways. In other words, it tells us how well the company uses its capital to generate profits and create shareholder value.

A weighted average cost of capital (WACC) shows investors how much it costs a company to finance its business. When the ROIC exceeds the WACC, the business creates shareholder value. If the ROIC is less than the WACC, the business is destroying shareholder value.

Investor beware: This is a more complex formula to calculate. ROIC can be influenced by non-operational factors and may overlook overall capital efficiency.

Return on Capital Employed (ROCE)

Formula: ROCE = EBIT/(Total assets - current liabilities)

ROCE is found by dividing EBIT (earnings before interest and taxes) and dividing it by the difference between total assets and current liabilities. Assets are any item of property owned by the company that has value. Current liabilities are bills due within the following year. This could include wages owed to workers, money owed to suppliers, and taxes owed to the government.

EBIT is found on the income statement. Both assets and current liabilities are found on the balance sheet.

Why it matters: This ratio measures how efficiently a company uses its available capital (both equity and debt) to generate profits.

Investor beware: ROCE can be skewed by high debt levels and is not effective for comparisons (Which is why you won't see it used as often as the other ratios on this list).

Tips on using these calculations

It’s almost always best to use these calculations to compare with peers in the same industry. For instance, comparing a bank’s ROA with a software company’s ROA doesn't make sense, as they share vastly different asset bases.

While it’s good to understand the math behind these calculations and where they come from, you do not need to crunch these numbers every time you study a company!

Many financial data aggregators, such as our preferred partner finchat.io, provide these numbers to investors.

Key Takeaway

Understanding ROE, ROA, ROIC, and ROCE is crucial for evaluating a company's financial performance and its ability to generate returns on capital. Each metric provides unique insights, from profitability efficiency to capital utilization, but investors must be aware of their limitations and potential distortions.

It's important to compare these ratios within the same industry for meaningful analysis, as different sectors have varying capital structures.

While mastering the underlying formulas is beneficial, leveraging financial tools and data aggregators can simplify the process and enhance decision-making.