ROI vs ROCE: Which one is better?

Summary

• ROCE can only be used when comparing companies within the same industry, whereas ROI is more flexible and is used to compare a variety of assets.
• Both measures help determine the efficiency of how well a company utilises its capital.
• In both the ratios, any value greater than zero reflects net profitability, and higher values indicate a more effective use of capital investment.

Analysing some of the key financial ratios of a company helps an investor to take much better informed decisions. Financial ratios are created using numerical values taken from financial statements of the companies to gain some meaningful information. These numbers found on a company’s financial statements such as income statement, balance sheet and cash flow statement are used to perform quantitative analysis and assess a company’s growth, rate of returns, liquidity, margins, valuation, and much more.

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These ratios also help to solve one of the most crucial aspects of investing, i.e. comparing two different companies based on common parameters. This makes it easier to identify which one of the lot is better based on some common grounds.

ROI vs ROCE

Two of the most important ratios to determine the viability of an investment are return on investment (ROI) and return on capital employed (ROCE). They may sound similar, but there is a difference between both. However, both of these profitability ratios go beyond a company's basic profitability to provide a more comprehensive assessment of how successfully the management runs the company and returns value to investors.

ROCE can only be used when comparing two or more companies within the same industry, whereas ROI is a more flexible ratio and can be used to compare a variety of assets. However, ROI does not consider time periods.

Capital employed is the total amount of a company’s assets minus current liabilities. In other words, it’s the available capital with the company from net profits. A higher the value being derived using the below formula, translates to a more efficiently run company with respect to its capital utilisation. It is critical that ROCE must exceed the cost of capital  or the company may face financial distress.

Formulae for calculating ROCE                   ROCE=EBIT

                                                                           Capital Employed

ROCE can be very useful for comparing the use of capital by different companies engaged in the same business, particularly in regard to capital-intensive industries, such as energy, auto, and telecommunications firms.

ROI, on the other hand, is a popular profit metric used to evaluate a company’s investments and its financial consequences with respect to cash flow. The ROI is generally calculated in a percentage, and is calculated as follows:

Formulae for ROI:                                            ROI= Return on Invstment

                                                                                       Cost of Investment

Any value higher than zero reflects that the company is net profitable, and higher values indicate even more effective use of investment. On the other hand, a negative value shows an extremely poor capital management, resulting in net loss.

ROI can be used as a general gauge of an investment’s profitability. The ROI can be calculated on a stock investment, a company can calculate RO on expanding a factory, or even on a real estate transaction.

Read More: Fundamental risk management strategies for active traders

So which one is better?

Both measures help determine the efficiency of how well a the management is utilizing the capital. ROCE is a more specific gauge to measure return than ROI, but it’s only useful when used with the analysis of companies within the same industry. Also, the numbers used must cover the same period.

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On the other hand, ROI is a bit more flexible, as it can be used to compare many assets, and also projects and various investment opportunities. The limitation of ROI is that it doesn’t take time into consideration.

A couple of investments can have the same ROI and yet one can generate that return over a year, while another may take a decade. The ROI calculation also doesn’t account for taxes, which are important for a company's bottom line.

ROI can be utilised by companies internally to evaluate the profitability of production of one product versus another in order to determine which product's manufacturing and distribution represents the company's most efficient use of capital.

Read More: What Is Return On Invested Capital (ROIC)?