Return on equity (ROE) and return on capital (ROC) measure very similar concepts, but with a slight difference in the underlying formulas. Both measures are used to decipher the profitability of a company based on the money it had to work with.
- ROC and ROE are well-known and trusted metrics used by investors and institutions to decide between competing for investment options.
- Return on equity (ROE) measures a corporation's profitability in relation to stockholders’ equity.
- Return on capital (ROC) measures the same but also includes debt financing in addition to equity.
- All else equal, most seasoned investors would choose to invest in a company with both higher ROE and ROC compared to a company with lower ratios.
- Shareholders will pay more attention to ROE since they are equity holders.
Return on Equity (ROE)
Return on equity measures a company's profit as a percentage of the combined total worth of all ownership interests in the company. For example, if a company's profit equals $10 million for a period, and the total value of the shareholders' equity interests in the company equals $100 million, the return on equity would equal 10% ($10 million divided by $100 million).
The formula for calculating ROE is as follows:
Return on equity=Average shareholders’ equityNet income
There are a number of different figures from the income statement and balance sheet that a person could use to get a slightly different ROE. A common method is to take net income from the income statement and divide it by the total of shareholder equity on the balance sheet.
If a company had a net income of $50,000 on the income statement in a given year and recorded total shareholders equity of $100,000 on the balance sheet in that same year, then the ROE is 50%. Some top companies routinely have an ROE north of 30%.
Return on Capital (ROC)
Return on capital, in addition to using the value of ownership interests in a company, also includes the total value of debts owed by the company in the form of loans and bonds.
For example, if a company's profit equals $10 million for a period, and the total value of the shareholders' equity interests in the company equals $100 million, and debts equal $100 million, the return on capital equals 5% ($10 million divided by $200 million).
The formula for calculating ROC is as follows:
Return on capital=Debt+EquityNet income
As with ROE, an investor could use various figures from the balance sheet and income statement to get slightly different variations of ROC. Ultimately what matters is that the investor uses the same calculation over time, as this will reveal whether the company is improving, staying the same, or declining in performance over time.
If a company had a net income of 50,000 on the income statement in a given year, recorded total shareholders equity of 100,000 on the balance sheet in that same year, and had total debts of 65,000, then the ROC is 30% (50,000 / 165,000). This is a very quick way to calculate ROC, but only for very simple companies. If a company has lease obligations this too needs to be factored in. If a company has one-time gains that aren't useful for comparing the ratio year-to-year, then these would need to be deducted.
An ROC higher than the cost of capital means a company is healthy and growing, while an ROC lower than the cost of capital suggests an unsustainable business model.
Frequently Asked Questions
What is ROC in finance?
Return on capital (ROC) measures a company's net income relative to the sum of its debt and equity value. It is effectively the amount of money a company makes that is above the average cost it pays for its debt and equity capital.
What is the link between ROI and ROE?
Return on investment (ROI) is an approximate measure of an investment's profitability. ROI is expressed as a percentage and is calculated by dividing an investment's net profit (or loss) by its initial cost or outlay. Since equity is a form of capital, ROE can indicate profitability on that sort of investment.
Is ROE the same as ROIC?
ROIC is another way of saying ROC. ROC takes into account both debt and equity, while ROE only looks at equity.