📚 PASS Research Analyst Certification Examination Difficulty: Intermediate ℹ️ Info   ~5 min read
📌 Chapter 8.11 — Commonly used ratios

You are deep into your research on two competing companies in the Indian chemical sector. Both companies report an identical Return on Equity (ROE) of 18%, suggesting they are equally efficient at generating returns for shareholders. However, when you dig into the debt levels, you realize Company A is highly leveraged, inflating its ROE through borrowed capital, while Company B is largely debt-free. To normalize this distortion, you must turn to Return on Capital Employed (ROCE), which evaluates the efficiency of the entire capital structure, encompassing both equity and debt.

ROCE measures the returns a company generates from all capital providers, not just shareholders. By using EBIT in the numerator and Capital Employed (Total Assets minus Current Liabilities) in the denominator, this ratio provides a clearer picture of operational performance. It reflects how well management utilizes the total financial resources at its disposal to generate earnings. In an environment where capital costs in India can vary significantly, ROCE acts as the ultimate litmus test for whether a firm is creating value above its cost of capital.

Consider an infrastructure firm heavily reliant on long-term loans for project execution. If you rely solely on ROE, you might overlook the fact that the company’s operating assets are failing to generate sufficient returns to cover the interest burden. A healthy ROCE indicates that the business model is inherently profitable regardless of how it is financed.

For an analyst, this is the first step in assessing ‘Economic Value Added’; if the ROCE is significantly higher than the company’s weighted average cost of capital (WACC), the firm is essentially creating wealth for its stakeholders.

When comparing firms, always adjust your calculation to include total capital employed, ensuring consistency across the industry. For capital-intensive sectors like manufacturing or utilities, ROCE is far more indicative of long-term viability than ROE. While ROE can be manipulated through aggressive financial leverage, ROCE keeps the focus firmly on the underlying business engine. As you refine your valuation models, prioritizing ROCE will allow you to identify high-quality businesses that generate returns through operational excellence rather than accounting engineering.1

Nuance

⚠️ Nuance
A common pitfall for candidates is failing to align the numerator with the denominator when calculating ROCE. Because the denominator (capital employed) includes debt, you must use EBIT—which is pre-interest—as the numerator to ensure an ‘apples-to-apples’ comparison. Analysts often incorrectly use Net Profit, which has already been reduced by interest payments, thereby punishing companies with high debt levels unfairly and masking their operational efficiency.

Check Your Understanding

Practice Question 1

A firm has an EBIT of 500, a Total Debt of 1,000, and Total Equity of 1,500. Current Liabilities are 500. What is the ROCE?

Practice Question 2

Which of the following statements best describes the primary advantage of using ROCE over ROE in financial analysis?

This is a companion read for Section 8.11 — Commonly used ratios from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. Capital Employed is technically calculated as Total Assets minus Current Liabilities, effectively representing the sum of Shareholder’s Equity and Total Debt. ↩︎