Thursday, November 22, 2012

Return On Equity Vs. Return On Capital

Return on Equity indicates how well a company is doing with the money it has now, whereas Return on Capital indicates how well it will do with further Capital.

Return on Equity is an accounting valuation method which calculates the amount of profit a company earned in comparison to the total amount of shareholder's equity found on the balance sheet. ROE is a useful tool in comparing the profitability of a company to the other firms in the same industry. Return on Equity is calculated by dividing the net income of the company by the total amount of its shareholders equity, i.e.; Net Income/ Shareholders Equity. Where the net income is the earnings taken from the consolidated Statements of earnings in the company's last annual filing with the Securities Exchange Commission (SEC), or they can also be taken as the sum of the last four quarters of the earnings. Shareholder's Equity, is the difference between the total assets and total liabilities and can be found on the balance sheet. Return on Equity is of great interest to the common stock holders as it focuses on the company's profitability based on the book value of the common equity. One of the quickest ways to gauge whether a company is an asset creator or a cash consumer is to look at the Return on Equity that it generates. By relating the earnings generated to the shareholder's equity, an investor can quickly see how much cash is created from the existing assets.

Return on Equity consists of three main ingredients i.e. profitability, asset management, and financial leverage. Therefore, looking at the composite value of Return on Equity, the investors can get a fair idea of whether they will receive a good Return on Equity or not and also an idea of management's ability to get the job done. A high Return on Equity may be due to a high return on assets or a result of extensive use of debt financing or a combination of both.

Return on Capital on the other hand is a measure of how effectively a company uses its money (whether borrowed or owned), invested in its operations. It is also perceived as a distribution of cash resulting from depreciation, tax savings, the sale of capital assets or securities or any other transaction unrelated to the retained earnings. It is a ratio that indicates the efficiency and profitability of a company's capital investments. Return on Capital is calculated by dividing the profit before interest and taxes by the difference between total assets and total liabilities, to be precise, ROC= EBIT/Total assets- Total Liabilities. ROC should always be higher than the rate at which the company borrows at, otherwise any increase in borrowings will reduce shareholder's earnings.

Return on Equity indicates how well a company is doing with the money it has now whereas Return on Capital indicates how well it will do with further capital. However, Return on Equity gives a better idea of what a company can achieve with its profit and how fast its earnings are likely to grow. Of course, if long term debt is small, then there is little difference between the two ratios. If your data source does not give you Return on Capital for a company, then it is easy enough to calculate it from Return on Equity. Also there is no tax on Return on Capital.