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ROI or ROCE?

Return On Investment (ROI) is a measure of how efficiently the investor’s money is deployed, utilized and returns generated by the business. The analysis is mainly from the investor’s perspective.

On the other hand, Return On Capital Employed (ROCE) measures the efficiency of the total capital employed in the business, including borrowings. It also evaluates whether the business is earning more than prevailing interest rates.

Let us study the following example:

	Aggressive Ltd.	Conservative Ltd.
	Rs. In million	Rs. In million
Equity Capital	100.00	100.00
Loans	400.00	100.00
Current Liabilities	400.00	100.00
Fixed Assets (Net Block)	400.00	100.00
Current Assets	500.00	200.00
Net Working Capital	100.00	100.00
Sales	2500.00	1000.00
Profit Before Interest and Tax (PBIT/ EBIT)	100.00	55.00
Interest	60.00	15.00
Profit Before Tax	40.00	40.00
Income/ Corporate Tax	10.00	10.00
Profit After Tax	30.00	30.00
Rate of Interest	15.00%	15.00%
ROI	30.00%	30.00%
ROCE	18.00%	22.50%
Total Outside Liabilities (TOL)/ Tangible Net Worth (TNW)	8	2
Current Ratio	1.25	2
Debt-Equity Ration	3	1

It is evident that even though the ROI is the same in both companies, Aggressive Ltd. is financially weaker compared to Conservative Ltd., on the following counts:

· Conservative Ltd.’s ROCE is much more healthier than the former’s 18%;

· The return on total capital employed of Aggressive Ltd., at 18% is just a tad above the market interest rate of 15% - when a business is not earning significantly better than the borrowing cost, there is no great advantage in running a business involving huge risks, instead the money can be invested in safe bonds and fixed income securities! Whereas latter is earning an additional 7.5% over and above the interest rate, justifying itself to be in business.

· Aggressive Ltd., highly leveraged with higher debt-equity, TOL/ TNW and lower current ratios.

Therefore one should not be obsessed with ROI and consider ROCE which is a better indicator of the efficiency of the total capital employed in the business.

Of course, ROCE has it’s own weaknesses. Older businesses, with highly depreciated assets, tend to show better ROCE than new businesses, etc., which we will discuss in other articles.

I welcome your comments.

P.Anand

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