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Financial Ratios

# Understanding Profitability Ratios

Created on 21 Feb 2023

Wraps up in 8 Min

Updated on 28 Feb 2023

Investing in stocks can be a daunting task, especially when trying to understand the various financial metrics used to evaluate a company's performance. Return on capital is one such indicator, which is used to assess how effectively a business uses its invested capital to produce profits. There are several variations of this metric, including ROCE, ROIC, and ROIIC, each with its own unique calculation and interpretation.

In this article, we will explore these different types of return on capital ratios and explain how they can help you make informed investment decisions. Whether you have experience investing or are a beginner, understanding these metrics is crucial to maximising your returns and building a strong investment portfolio. So, let's dive in!

## What is ROCE?

The financial indicator known as return on capital employed (ROCE) can be used by analysts and investors to assess a company's profitability and capital efficiency. The formula for calculating ROCE is EBIT (Operating Profit) divided by (Total Assets - Current Liabilities).

Because it demonstrates how well a business uses its capital to produce profits, ROCE is a crucial indicator to take into account when assessing a company's success. An organisation effectively uses capital to generate value for its shareholders if its ROCE is high.

ROCE is particularly useful when comparing companies in the same industry or sector. For example, let's consider two companies, Company A and Company B, in the retail industry. Company A has total assets of ₹100 crore and total liabilities of ₹50 crore, while Company B has total assets of ₹200 crore and total liabilities of ₹75 crore.

To calculate the ROCE for each company, we divide their earnings before interest and taxes (EBIT) by the total capital employed. Suppose Company A's EBIT is ₹10 crore, and its total capital employed is ₹50 crore (the amount of total assets minus total liabilities). This gives a ROCE of 20% (₹10 crore divided by ₹50 crore).

Now, suppose Company B's EBIT is ₹25 crore, and its total capital employed is ₹125 crore (the amount of total assets minus total liabilities). This gives a ROCE of 20% (₹25 crore divided by ₹125 crore).

This means that both Company A and Company B have the same ROCE of 20%. It indicates that both companies are generating the same amount of profit relative to the capital they employ in their operations.

ROCE is a useful tool for investors to compare the financial efficiency of different companies in the same industry. In this case, we can conclude that both Company A and Company B have the same level of efficiency in using their capital to generate profits. It can also help companies make better financial decisions by evaluating the profitability and efficiency of new projects. However, investors need to consider other factors, such as risks, growth potential, and competition, before making investment decisions.

## What is ROIC?

Return on invested capital (ROIC) is another powerful metric for evaluating a company's ability to generate profits from its investments. It measures how efficiently a company is using the capital invested in it to generate returns, taking into account both debt and equity. A high ROIC indicates that a company is using its capital effectively and creating value for its shareholders.

To calculate ROIC, you need to divide EBIT (earnings before interest and taxes) by invested capital. Invested capital is the total amount of capital that a company has put into its operations, including debt and equity. The formula for ROIC is as follows:

ROIC = EBIT * (1 - Tax Rate) / Invested Capital

Taxes are removed from the calculation of NOPAT because it reflects a company's operational profitability, which is the amount of profit generated solely from its core business operations, independent of any tax benefits or expenses.

By adjusting EBIT for taxes, we get  NOPAT, which allows for a more accurate assessment of a company's operational efficiency, and it is particularly useful for comparing the performance of companies in different tax jurisdictions or with varying tax structures.

Let's consider two companies, Company A and Company B, in the same industry that both produce and sell appliances. Company A has invested a total of ₹10 crore in its operations and generates ₹2 crore in annual net operating profit after taxes (NOPAT), while Company B has invested a total of ₹20 crore in its operations and generates ₹3 crore in annual NOPAT.

To calculate the ROIC for each company, we divide the annual NOPAT by the total invested capital. Company A's ROIC would be 20% (₹2 crore NOPAT divided by ₹10 crore invested capital), while Company B's ROIC would be 15% (₹3 crore NOPAT divided by ₹20 crore invested capital).

This means that Company A generates ₹0.20 in NOPAT for every dollar of capital it has invested, while Company B generates ₹0.15 in NOPAT for every dollar of capital it has invested.

ROIC can be used to compare the profitability of various businesses operating in the same industry. In this case, Company A has a higher ROIC than Company B, indicating that it is more efficient at generating profits relative to the amount of capital it has invested. This may suggest that Company A is using its resources more effectively and is more financially efficient. Merely having a higher amount of investment or return in numerical terms does not necessarily equate to greater profitability. It is important to consider the percentage in order to provide meaningful context and allow for comparisons to be made.

However, it's important to note that ROIC is just one metric to consider when evaluating an investment. It would be best if you also considered other factors such as market conditions, competition, and future growth prospects.

## ROIIC: An extension of ROIC

Return on Invested Capital (ROIC) is an excellent metric to evaluate a company's ability to generate profits from its investments. However, when looking for a more powerful metric that can measure the change in earnings over time as a ratio to the change in investment, we have ROIIC.

ROIIC stands for Return on Incremental Invested Capital, and it measures the change in earnings as a percentage of incremental investments. The formula to calculate ROIIC is the NOPAT(current) divided by the change in invested capital in the previous period.

Investors and analysts use ROIIC to assess a company's ability to create value by measuring how well a company utilises its incremental investments. A high ROIIC indicates that a company is using its capital efficiently to generate returns.

However, it is important to understand that ROIIC is better suited for forecasting the trend of future returns rather than measuring the current return on investment. Therefore, companies should aim for a high ROIIC over an extended period, which demonstrates that their business is capital-efficient and has a higher operating leverage.

Being "capital-efficient" means that a company can generate higher levels of revenue using relatively less capital investment. Whereas higher operating leverage means that it is able to earn more profit by keeping its fixed costs (such as rent, salaries, and equipment) at a stable level while reducing its variable costs (such as raw materials or labour).

Let's say we have two companies, Company A and Company B, in the same industry that are both considering investing in new technology to improve their production processes. Company A invests ₹1 crore in new technology and generates an additional ₹200,000 in profits over the next year, while Company B invests ₹2 crore in new technology and generates an additional ₹300,000 in profits over the same period.

Now, let's look at the Return on Incremental Invested Capital (ROIIC) for each company. ROIIC is a measure of how efficiently a company is using its new investments to generate additional profits. It tells you how much additional profit a company generates for every dollar it invests in new projects or ventures.

To calculate the ROIIC for each company, we divide the additional profit generated by the incremental capital invested. Company A's ROIIC would be 20% (₹200,000 profit divided by ₹1 crore incremental capital invested), while Company B's ROIIC would be 15% (₹300,000 profit divided by ₹2 crore incremental capital invested).

While Company A has a higher ROIIC than Company B, it's important to consider other factors, such as the size and growth potential of each company, as well as the risks associated with the new technology investment. A higher ROIIC doesn't necessarily mean that an investment is the better option, as there may be other factors to consider.

In conclusion, ROIIC is a powerful metric that measures a company's ability to generate returns on incremental investments. Investors and analysts can use ROIIC to evaluate a company's capital efficiency, which can help them make more informed investment decisions. Companies should aim for a high ROIIC over time, which indicates that they are capital-efficient and have a higher operating leverage.

## Are ROCE and ROIC similar/the same?

Investors analyse lucrative businesses for investment using ROCE and ROIC. They can use both ratios to gauge a company's performance and the percentage of net reported earnings that are distributed as dividends. The ratios also provide investors with information on the company's utilisation of capital and potential for future revenue growth.

### Comparison of ROCE and ROIC

If the ROCE exceeds the cost of capital, the business is said to be profitable or to be successfully using its capital. If a company's ROIC value is higher than zero, it can be said that it is profitable. When the ROCE is below the cost of capital or the ROIC is negative, the company has not utilised the invested capital successfully.

The fact that ROCE is based on pre-tax data, whereas ROIC is based on after-tax figures, is another significant distinction between ROIC and ROCE. As a result, from the standpoint of the company, ROCE is more important, whereas ROIC is more important from the perspective of the investor because it indicates the likely amount of dividends the investor would receive. ROCE becomes most useful when used for comparing businesses with those in other nations or tax systems. However, ROIC can be used to compare businesses with similar tax structures and draw conclusions quickly.

#### The Bottom Line

In conclusion, understanding the different metrics that businesses use to measure their financial performance is crucial for anyone involved in the world of finance or entrepreneurship. The concepts of ROCE, ROIC, and ROIIC are vital tools that can help investors, analysts, and managers determine the profitability and efficiency of a company.

ROCE measures how much a company is earning relative to the amount of capital invested in the business. It is an essential indicator of how well a company is using its resources to generate profits. On the other hand, ROIC focuses on the efficiency of a company's investments, analysing the returns generated from its invested capital.

Finally, ROIIC is a more nuanced metric that considers both the cost of capital and the reinvestment of profits in a business. It is a comprehensive metric that helps investors and analysts understand the long-term profitability of a company and its ability to create value over time.

By understanding these metrics, business owners, investors, and analysts can make informed decisions about where to invest their capital and which companies are worth their time and resources. Ultimately, these financial metrics play a critical role in determining the success of any company, and those who can master them will have a competitive edge in the ever-changing world of finance and business.

An Article By -

Rishabh Kaushik

12 Posts

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Rishabh is a finance enthusiast who is in a love-hate relationship with writing. Armed with a wicked sense of humour, he delivers jokes that land 50% of the time... Every other instance crashes and burns as he does after his lunch. To add more about this guy, he is into absurd comedy, can play the guitar (or so he says), and is a social pendulum.

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