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

Imagine you are reviewing two manufacturing firms listed on the NSE. Firm A reports an impressive Return on Equity (ROE) of 25%, while Firm B shows a modest 18%. A novice analyst might immediately recommend Firm A, but as an NISM-certified professional, you know that ROE can be inflated by high financial leverage. To look past the debt-fueled earnings, you pivot to Return on Capital Employed (ROCE), which measures how efficiently a company uses its total capital—both equity and debt—to generate operating profits.

ROCE is calculated by dividing NOPAT by Capital Employed (Total Assets minus Current Liabilities). While ROE focuses solely on the shareholder’s return, ROCE provides a holistic view of the company’s operating efficiency regardless of how it is financed. If Firm A’s high ROE is a result of excessive borrowing, its ROCE will likely reveal a mediocre return on its actual business assets. Conversely, if Firm B maintains a superior ROCE, it indicates that its core operations are genuinely creating value, making it a more robust candidate for long-term investment.

In the Indian context, where capital intensity varies significantly across sectors like Infrastructure and IT, ROCE is an essential diagnostic tool. A capital-intensive firm like a steel manufacturer requires massive investments in plant and machinery, and an analyst must determine if these assets are generating sufficient returns to cover the cost of capital. If a company’s ROCE consistently stays below its Weighted Average Cost of Capital (WACC), it is effectively destroying shareholder value despite what its topline revenue growth might suggest.

By incorporating ROCE into your valuation models, you move beyond surface-level accounting performance. It allows you to identify firms with a sustainable competitive advantage—often called an ’economic moat’—which are capable of compounding capital effectively over time. When your research report highlights a firm’s ability to maintain high ROCE even during cyclical downturns, your investment recommendation carries far more weight, demonstrating a deep understanding of corporate finance strategy rather than simple ratio-crunching.

Nuance

⚠️ Nuance
A common pitfall is the failure to adjust for ‘Cash and Cash Equivalents’ when calculating capital employed. Many candidates simply subtract current liabilities from total assets, forgetting that excess cash balances—which are non-operating assets—can artificially depress the ROCE. A rigorous analyst should consider using ‘Operating Capital Employed’ by excluding non-operating cash, ensuring the ratio reflects the efficiency of the core business engine rather than the company’s idle treasury management.

Check Your Understanding

Practice Question 1

Company X has an ROE of 22% and a Debt-to-Equity ratio of 2.5x, while Company Y has an ROE of 18% and a Debt-to-Equity ratio of 0.2x. Based on capital efficiency, which firm is likely the stronger operator?

Practice Question 2

Why does an analyst prefer ROCE over ROE when comparing a cement manufacturer to an IT services firm?

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.

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