The Sunday Mail
Return On Equity: The Return On Equity ratio essentially measures the rate of return that the owners of common stock of a company receive on their shareholdings. Return on equity signifies how good the company is in generating returns on the investment it received from its shareholders.
Description: Mathematically, Return on Equity = Net Income or Profits/Shareholder’s Equity.
The denominator is essentially the difference of a company’s assets and liabilities. It is the amount left over, if an organisation decides to settle its liabilities at a given time.
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Return Of Capital: Return on Capital Employed or RoCE essentially measures the earnings as a proportion of debt+equity required by a business to continue normal operations.
In the long run, this ratio should be higher than the investments made through debt and shareholders’ equity.
Otherwise, diminishing returns shall render the business unsustainable. This is a better measure of financial health of a company than return on equity or RoE, because it takes into account the contribution of debt while showing the company’s return.
Description: ROCE. = (Earnings from operations — interest and liabilities) / (Shareholders equity + debt)
Suppose ABC Corp had a net operating profit from operations as $10 000. It reported in the balance sheet equity worth $10 000 and liabilities worth $2 500. ROCE= 10 000 / (10 000+2 500) = 0,8.
This means for every dollar invested in ABC Corp, the firm generates Re 0,8. From this angle, ABC Corp does not look like a financially-healthy organisation.
ROCE is measured on an annual basis and plotted as a year-on-year trend line to see any noticeable change that might be occurring in the performance of the company. ROCE also has a few drawbacks.
First, it tends to compare the current earnings with the book value of assets. So, an organisation with depreciated assets will have more ROCE than a new organisation, even if they generate similar revenue using the same capital machinery.
Profits can often be distorted using accounting policies or due to any other short-term influences. Also, for firms that do not disclose their performances to public, the ROCE data cannot be calculated accurately.
Yet, using ROCE as a performance metric is considered far more useful, especially when it is used to compare a company’s returns with peers operating in the same sector.
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Required Rate Of Return: Required Rate of return is the minimum acceptable return on investment sought by individuals or companies considering an investment opportunity.
Description: Investors across the world use the required rate of return to calculate the minimum return they would accept on an investment, after taking into consideration all available options. When calculating the required rate of return, investors look at overall market returns, risk-free rate of return, volatility of the stock and overall project cost.
The required rate of return drives the type of investments that can be made. For instance, someone requiring a higher rate of return would necessarily have to look at riskier investments. Finance professionals routinely calculate the required rate of return for purchasing new equipment, new product roll-outs and potential mergers.
For example: an investor who can earn 10 per cent every year by investing in US Bonds, would set a required rate of return of 12 per cent for a riskier investment before considering it.
Formula for Required Rate of Return Required Rate of Return = Risk Free Rate + Risk Co-efficient (Expected Return — Risk free return)
