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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? 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?

    In my understanding, repayment of loan would decrease payables in current liabilities, increase Capital
    Employed and ultimately decrease Return of Capital Employed?

Any help is appreciated. Thank you very much.

1 Answer 1

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Let's answer the questions one at a time.

  1. Always try to match the cash flow with the source of capital. You use net income for ROE because this is the cash flow to the equity investors. Interest payments go to debt holders and taxes to the government. On the contrary, you use EBIT for ROA because you are interested on the total performance, not only equity or debt. So you need to use all cash flow generated by the company from all sources (assets).

  2. This one seems strange to me at face value. Maybe if you provide more information I'll be able to help out, because ceteris paribus (all else being equal) higher operating profit (I assume same indirect costs) should lead to higher ROCE.

  3. Loans are long-term debt and not in accounts payable and thus, located under non-current liabilities. Hence, your denominator is smaller and your fraction (ROCE) higher. That's the easy answer by just looking at the formula. The essence of loan repayment is that you have less capital employed to finance your assets that produce your revenue.

Hope this helps. If this answered your question, don't forget to mark it as the accepted answer.

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