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Questions about Financial Ratio

Howard (Howard) (29 Points)

18 March 2020

Hello Everyone. I am doing some tutorial questions about financial ratio and encounters some problems that I would like to share in this forum.

1. Why we use Profit AFTER Interest & Tax as numerator in Return of Equity whereas Profit BEFORE Interest & Tax in Return of Assets?

2. Why increase in Gross Profit will decrease Return of Capital Employed?

3. Why repayment of loan will decrease Capital Employed, which in turn increase Return of Capital Employed?

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8 Replies

sabyasachi mukherjee (26057 Points)
Replied 18 March 2020

1. question has to be more specific.
2.increase of gross profit can decrease return on capital employed.
It's how u manage your indirect expenses.

Howard (Howard) (29 Points)
Replied 18 March 2020

ROE = Profit after tax for ordinary equity holders / Share Capital plus Reserves *100

ROCE = Operating profit (before interest + tax) / Capital Employed *100

Why didn't we use Operating profit (before interest + tax) as numerator in ROE?

sabyasachi mukherjee (26057 Points)
Replied 18 March 2020

One is ROE
ANOTHER IS ROCE..

SO both are different concepts altogether...
one is return on Equity
Equity holders are always concerned after tax profit
this tool is used for investment analysis.
ROCE IS used for capital employed in investment decision.

Howard (Howard) (29 Points)
Replied 18 March 2020

Do you mean ROE is usually for shareholders to evaluate the company performance, whereas ROCE is for manager to decide the amount of investment in capital?

But why do we not use Profit after tax in ROCE?

Vivek Kurup (.) (355 Points)
Replied 19 March 2020

In ROE, we use the PAT because it’s a measure of earnings of the equity holders. The earnings of the equity holders are the earnings of the company after tax.

In contrast, in ROCE we are evaluating how effectively we have utilized the capital employed in the company to generate income, over a period of time or in comparison with other companies in the same industry. Here we don’t use the PAT since the tax expenses are fixed by an external source viz. government and it can change from year to year.

For example consider a hypothetical company having same amount of income and expenses (excluding tax expenses) for a consecutive 2 years and the tax rate for the 1^st year was 30% and for the 2^nd year is 25%, resulting in an incremental PAT in the 2^nd year.

If we use PAT for ROCE, the above company shall show a higher ROCE in the second year, which is not because of the effective utilization of the capital employed; but merely because of a change in government policy. Here we cannot say that the company has utilized its capital more effectively in the 2^nd year, merely because of a higher ROCE. Therefore, using PAT in ROCE shall not show a correct picture of the effective utilization of the capital employed.

On the other hand, in the above example, the higher ROE in the 2^nd year is correct since the earning of the equity holders have been increased due to the reduction in tax expenses.

Hope you understand the concept!

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Howard (Howard) (29 Points)
Replied 23 March 2020

Thank you so much @ CAVVK. This is a very detailed explanation. To improve the explanation, shall I say we do not use PAT for ROCE for the following reasons?

ROCE is more like an internal performance indicator which should not take any external factors such as tax into account.
Tax has no direct relation with capital employed

For question 2 and 3, I have come up with some arguments.

2. Why increase in Gross Profit will decrease Return of Capital Employed?

Shouldn’t increase in gross profit will push up Profit BEFORE Interest & Tax and increase Return of Capital Employed?

3. Why repayment of loan will decrease Capital Employed, which in turn increase Return of Capital Employed?

Isn’t it that repayment of loan would decrease payables in current liabilities, increase Capital Employed and ultimately decrease Return of Capital Employed?

sabyasachi mukherjee (26057 Points)
Replied 24 March 2020

No not necessarily.

one assumption needs to made.
profit before interest and tax will increase return on capital employed.
if my profit remains same but capital employed is decreased.

generally capital employed is defined as fixed asset plus working capital.
working capital is current asset minus current liabilities.
here the initial query was:
why we use profit after tax for equity holders.
they get share of profits after tax.
for computation any long term investment .
we use pbit.
any tax paid will certainly reduce liability.

Howard (Howard) (29 Points)
Replied 24 March 2020

@ sabyasachi

If I am not mistaken, did you mean *increase in* profit before interest and tax will increase return on capital employed given the capital employed remains the same?