Return on Equity is one of the crucial measures of the economic efficiency of a firm for its equity shareholders. Let us look at the relationship involving Return on Equity (ROE) and Return on Capital (ROC).
Let us look at Dipankar Ltd’s (DL) financials for its newest economic year: Earnings prior to interest and tax (EBIT) Rs 1,200 crore net revenue Rs 600 crore shareholders fund Rs 2,500 crore total assets Rs 6,000 crore present liabilities Rs 1,500 crore. The firm does not have interest bearing brief term debt and the extended term debt outstanding is Rs 2,000 crore (to be repaid just after 5 years in complete) with an interest price of 10% and applicable tax price for the firm is 40%.
Return on Capital (ROC)
The ROC is computed by dividing the just after-tax EBIT by the invested capital figure. After-tax EBIT for DL is Rs 720 crore. Invested Capital is Rs 4,500 crore (i.e total asset minus total present liabilities, so Rs 6,000 crore minus Rs 1,500 crore). Invested capital could also be computed as the sum of shareholders’ funds and extended-term debt (for DL it is Rs 2500 crore plus Rs 2,000 crore). Hence, ROC for DL is 16% (Rs 720 crore / Rs 4,500 crore *one hundred). This indicates that DL earns Rs 16 as ROC for each and every Rs one hundred as invested capital.
Deriving ROE from ROC
In truth, ROE could be computed as the sum of ROC and the excess of ROC more than debt-equity occasions just after-tax interest. For DL, ROC is 16%. Interest price is 10%. After-tax interest price is 6% i.e 10 (1-.40). Debt equity ratio of DL is .80 occasions i.e., debt/ equity (2,000/2,500 crore). Hence ROE for DL is = ROC + [ (ROC- After tax interest rate) * D/E] = 24% (16 %+ [(16%-6%) *0.80]. if we compute ROE for DL straight by dividing net revenue by its shareholders’ funds, we get the similar 24% (Net revenue / shareholders’ funds *one hundred = (1200-200) (1-.40) / 2500 *one hundred ).
Takeaway for young equity investors
While assessing the financial attractiveness of a target stock, young equity investors should assure that the target firm earns an ROE which is greater than that of its ROC. If the target firm’s ROE is much less than its ROC, then it indicates that the firm is unable to earn adequate return on its invested capital to spend its just after-tax interest charges on borrowing. Therefore, one of the strategies to locate out the top quality of investments made by a firm is to place it to the ROE minus ROC test. Dl passes this test as its ROC (16%) is greater than its just after-tax interest price of 6%.
The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur