Alchemist

In Profitability Ratio, how important are ROA, ROE, ROCE. And if ROCE is low, does it affect the reserves of the company? Company's operations might be lowly leveraged in case. So ROCE might flicker violently because of varying leveraging of operations from time to time. Some people prefer ROCE over the other two. Then can ROE provide steady figures in such cases?

Sorry if I make basic blunders.

These terms can be confusing for some.

There is one ROCE which is also called RNOA or ROIC.

Return on Capital Employed = Return on Net Operating Assets = Return on Invested Capital.

ROCE can also mean "Return on Common Equity", which is same as ROE, that we generally use in India.

Firstly, I assume, you are asking about the first ROCE, which is also called RNOA or ROIC.

Also, please clarify the following:

1. What "reserves" are you referring to?

2. What do you mean by "lowly leveraged"?

I assume that by "lowly leveraged", you mean under-utilization of capacity.

In that case, yes, ROCE would be below-potential. If in future, the capacity utilization goes up, ROCE will also increase.

ROE is also a function of ROCE (Return on Capital Employed). Thus, ROE cannot be steady if ROCE is volatile.

The relation between ROE and RONA is as follows:

ROE = RNOA + FL (RNOA - Cost of Debt).

FL is "Financial Leverage"; that is the Debt:Equity ratio that we generally use.

Consider the following data for a company:

PAT = (45-20) X 0.66 = 16.67 crore.

Using the above equation for pre-tax ROE:

ROE as calculated from PAT = 25/100 = 25%

ROE from equation = 15% + 2 (15%-10%)

= 25%.

Now try balancing the equation for post-tax ROE (usually the term ROE is used, it means post-tax ROE).

.

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Thanks Alchemist

1. By reserve I mean the revenue that is ploughed back after PAT and dividend.

2. By low leveraging I mean low borrowing for operations. Because then EBIT will also be low. Borrowing may change following different interest rates set by RBI. I might be wrong, don't know, but I think if interest rates are high companies borrow less loans.

"Operational leverage" is different from "financial leverage" and so I asked you to clarify.

What you are asking about is "financial leverage".

ROCE (Return on Capital Employed) is independent of financial leverage.

ROCE just tells us how profitable the assets held by the company are.

The assets may be financed by debt or equity. The final ROE will depend on the financial leverage that the company is using.

If the ROCE is greater than the pre-tax cost of borrowing, then ROE will increase with increase in financial leverage.

If the ROCE is less than the pre-tax cost of borrowing, then ROE will decrease with increase in financial leverage.

See the equation I have given in earlier post.

ROE = RNOA + FL (RNOA - Cost of Debt).

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"Reserves" can mean a lot of things. You can use the term "retained earnings" for profit that remains with the company after taxes and dividend.

If the ROCE (Return on Capital Employed) for a company is low, it means the assets of the company have low profitability.

Thus, the company will be making less profits, will be paying less dividend and retaining less earnings too.

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Oh thanks I got it now.

So financial leverage means how effectively management is using debts. And operating leverage means how the revenue is growing into profits over time.

I am completely from non-business and non-commercial background. So please
bear with me if I don't understand those terms.

Operational leverage can have different meanings too. I will need to make a separate thread for that. .

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Oh only if you wish.You have to invest time and work.

I am just posting other threads also to initiate the discussion and knowledge sharing.

Operational Leverage has more to do with Business risks, for a company to invest heavily in capacity expansion ( read fixed costs ) and then face low demand is painful for shareholders ( case in point : Phillips Carbon Black)

At the same time you there is a lot of debt, financial leverage is good to ride on during boom times with higher ROE, but the same can hurt during recessionary phase and can cause immense pressure on your bottom line with high interest burden ( check Phillips Carbon Black again ).