FINANCIAL ANALYSIS : Return on capital employed and return on equity
Return on capital employed is the book return generated by a company’s operations. It is calculated as operating profit after normalised tax divided by capital employed or as the NOPAT margin multiplied by asset turnover (sales / capital employed). Return on equity is the ratio of net profit to shareholders’ equity.
The leverage effect of debt is the difference between return on equity and return on cap- ital employed. It derives from the difference between return on capital employed and the after-tax cost of debt and is influenced by the relative size of debt and equity on the balance sheet. From a mathematical standpoint, the leverage effect leads to the following accounting tautology:
ROE=ROCE+(ROCE−i)× D E
The leverage effect works both ways. Although it may boost return on equity to above the level of return on capital employed, it may also dilute it to a weaker level when the return on capital employed falls below the cost of debt.
Book return on capital employed, return on equity and cost of debt do not reflect the returns required by shareholders, providers of funds and creditors. These figures cannot be regarded as financial indicators because they do not take into account risk or valuation, two key parameters in finance. Instead, they reflect the historical book returns achieved and belong to the realms of financial analysis and control.
The leverage effect helps to identify the source of a good return on equity, which may come from either a healthy return on capital employed or merely from a company’s capital structure, i.e. the leverage effect. This is its only real point.
In the long run, only a healthy return on capital employed will ensure a decent return on equity. As we shall see, the leverage effect does not create any value. Although it may boost return on equity, it leads inevitably to an increase in the risk of equity.